The Irish government may have discovered a fatal flaw in the Eurozone central banking system – the discount window.
In 2008 the Irish government bailed out Anglo-Irish Bank and effectively nationalized it. Since then they have been periodically supplying more bailout funds to it as losses have emerged. Because of this, together with the bailouts of other Irish banks and loss of tax revenues the Irish state’s finances are very bad. Currently the interest rate on Irish bonds is 8%, much higher than the Eurozone interest rate, indicating that the market considers the possibility of default to be high.
Many commentators have pointed out that having separate states issuing their own bonds and using their own tax policies within one currency area is destabilizing. But the current crisis in Ireland has revealed a problem that may be much bigger in the long run – the European Central Bank’s discount window.
The ECB, like most central banks, controls the rate of interest by two methods. They perform OMOs which are the buying and selling of bonds in exchange for base money. If the central bank buys a bond using base money then it increases the amount of base in circulation as reserves between the commercial banks. The central bank is also the lender-of-last resort. As part of that role the bank makes short term loans to the most marginal, that is most unstable, commercial banks. This is the “discount window” which the European central bank calls the marginal lending facility. The central bank can alter the rate of interest by offering discount window loans at higher or lower rates, though modern central banks don’t generally do this, they use OMOs instead.
The problem the ECB now faces is that it must make discount window loans to Irish banks that are owned by the Irish state. The ECB is, in effect, lending to the Irish government. As Ambrose Evans-Pritchard wrote yesterday: “…the ECB is already propping up Ireland and Club Med by unlimited lending to local banks that then rotate into their own government debt in an internal ‘carry trade’.” Since the ECB discount window rate is 1.75% and the interest rate on Irish government bonds is ~8% that means that Ireland is getting a good deal.
The ECB could stop this lending any time, and probably will. The problem, though, is the impartiality necessary in central banking. In the 19th century the Bank of England would occasionally lend to commercial banks having problems; it was the lender of last resort. But, as Bagehot pointed out, many problems were caused by the central bank playing favourites. Commercial banks with good connections at the Bank of England got loans and other banks without connections didn’t. So, it became a policy that the central bank should offer discount window loans at a rate higher than the prevailing interest rate to all commercial banks if they posted good collateral. Later central banks began performing regulatory probes into banks that borrowed from the discount window facility, thereby increasing the disincentive for banks to use it. The advantage of this system to the central banks was that the market knew that any commercial bank could borrow from the discount window, and that reduced the risk the banks took when lending to each other. This made monetary expansion much easier for the central bank to initiate than it had been before.
In the current situation, though, the ECB must play favourites. The ECB could justify that if it decides that the assets posted as collateral by the Irish banks are not satisfactory, and therefore that those banks are insolvent, not merely illiquid. But that would be mean that the ECB would be effectively judging that the Irish state is insolvent. Politically speaking, can a central bank make that judgement? If the ECB allows Ireland to continue borrowing from the discount window then the other wobbly Eurozone countries will follow Ireland — they will nationalize banks and use them to access the discount window. But if the ECB cut off lending to Ireland then this increases uncertainty for other Eurozone banks and states greatly.
Readers of this site will immediately realise that this recent article by Telegraph journalist Ambrose Evans-Pritchard is most confused. Much of our work aims to refute such muddy thinking.
I would love to hear from AEP, or from Prof Congdon, exactly how creating money is supposed to create wealth.
If the Central Banks of the world buy private sector bank debt, they create new demand-deposit money that the private sector banking system can then lend. So more money units chase the same goods and services? Where is the new wealth?
Many people associate rising money supply measures with rising GDP and increased prosperity. Mistaking correlation for causation, they view an increasing money supply as the source of prosperity. This puts the cart before the horse.
Wealth is only created when entrepreneurs make better goods and services, satisfying more of the needs of consumers, in better and more convenient and cheaper ways, via more capitalistic and hence more efficient methods of production. Both the capital investment and the subsequent purchase of the new goods and services should be supported by real savings (forgone consumption).
If such genuine wealth creation occurs, it will prompt banks to increase lending, and under our current system of fractional reserve banking this will necessarily entail an expansion of the money supply. This expansion is the result, not the cause, of wealth creation. Artificially increasing the supply of money will not create wealth, any more than injecting mercury into your thermometer will cause a rise in temperature.
As it is wealth we need to get us out of this hole, all policy should be directed at lowering taxes and reducing the burdens on entrepreneurs.
When it comes to central bankers, it is not dangerous defeatism we should fear, but catastrophic hubris.
Sean Corrigan has just sent me his views on the book “Dying of Money: Lessons of the Great German and American Inflations” which Andy Duncan wrote about here, setting off a number of interesting comments. Sean as ever helps put our thoughts straight on the matter. One does wonder if Ambrose Evans-Pritchard and the hordes of City people have actually read it.
Toby Baxendale.
Firstly, though I have to confess that I do use ‘velocity’ as a shorthand, now and again, the idea of using this aggregate twice-removed as more than a crude heuristic, much less as the lynchpin of one’s reasoning as Parsson seems to, is very suspect – see Mises and Rothbard on the topic.
Your ‘Dying of money’ man thinks that if the use of money in exchange were totally ‘efficient’, any amount of it would be inflationary – since ‘velocity’ would be infinite – and, conversely, that if all people wanted it for was as a store of ‘value’, we would need an infinite amount of it, since velocity would be zero.
The first seems to envisage a kind of grand, instantaneous goods clearing house which, however, does not do away with the double coincidence of wants argument (since even the most transient clearing house receipts would be needed to open up trade to all buyers and sellers and so would effectively BE money); the second would mean that money had ceased to be money (i.e., that favoured present good which acts as the medium of exchange) in any meaningful sense of the word -and probably that it would therefore rapidly lose its value, in any case.
To say, also, that the later stages of Weimar inflation were all about ‘velocity’ - itself a mysterious, mass hysterical construct under his analysis – when Havenstein was publicly bragging about how many more bank notes (of increasingly surreal denominations) were being printed is only to confuse the fact that the mark was losing real value faster than it was being created.
He further seems to think that, given a stable ‘velocity’, an increase in money supply commensurate with an augmented supply of what he loosely terms ‘real values’, is therefore not inflationary – hence he would have had no objection to 1920s America, 1980s Japan, or the West in much of the late 1990s and early 2000s – and so would have been a typical Real Bills enthusiast of monstrous misallocations of capital.
In most of the work, he shows himself a slave to his oft-quoted Friedmanite style of aggregative thinking and ignores Austrian insights into the role of relative pricing, injection effects, and the ideal that improved productivity should be met with proportionately falling prices of those particular goods if we are to avoid confusing entrepreneurial assessments.
Apparently, also, if the government issues debt during an inflation, this is a good thing, for it somehow retards its effect (sic), and, conversely, a government surplus is inflationary by, wait for it, ‘reducing the supply of real value’!
My reading of his argument is that interest is not the price of money (true enough), but money the price of interest (!) though he gives no explanation as to why interest itself arises (hint: time preference).
As a result of this, fixed interest (contracts), he argues, are ‘just as much as gold, a barbarous relic of the 19th century’. Much better to have equity contracts (partly true) or constant-value lending ensured by reference to a price index… Crankdom at its finest.
Government’s main task of management, he goes on, is to use tax policy to introduce ‘balance’ into the flow between saving and consumption – each of ‘equal merit… and contributing equally to well-being’. An Austrian need really look no further than this for a critical concentration of both economic and ethical error.
Late stage capitalism has, of course, a tendency to ‘excess’ saving (why? we may ask in vain), so Keynes’ only mistake was to argue for more government investment, as an offset, rather than using fiscal policy to penalise saving and promote consumption.
Government expenditure, it seems, is also a ‘national dividend’ and it is only right that the state should ‘give away purchasing power to help support consumption’ and it is mere ‘nostalgia’ to pine for a day where everyone looked after himself and the state had little or no involvement.
No, Leviathan should provide a national dividend by giving away all basic services freely: food, clothing, housing, and medical care – out of the ‘surplus prosperity’ – allowing people to concentrate ‘only’ on working to buy whatever else they need and not having to worry about being rendered technologically redundant.
I am only half way through this tract and already I have found more fallacies, inconsistencies, and shallow-thinking being marshalled behind a grandiose plan of reform, than I have seen in a long while. HG Wells would be proud of Parsson.
No wonder this tosh is out of print!!
All I can say is that this is typical of Evans-Pritchard’s Yellow journalism: everything we do is wrong and the whole system is always about to implode. But while we cannot let the Keynesians expand debt and deficits limitlessly, neither can we allow those horrible Liquidationists to cut back or, very soon, the 1930s will look like a picnic. We will have some form or other of ‘Flation (X-flation, perhaps) on some unspecified timescale or another – but, or course, it will be of an unimaginable magnitude when it does arrive, unless we stop everything we are doing now and yet intensify everything we are doing, at the same time.
One only regrets that Murray Rothbard is not still around to skewer the idiocies of such Swiftian buffoons as Parsson and his modern day brethren, AEP, Wolf, Kaletsky, Krugman, and Stiglitz – and to rebut the opposing follies of the self-loathing Guardianistas and Dollar-doom Michigan Militia, in general.
As for us, while it’s always nice to think we are not an isolated remnant in the cause, perhaps we might be just a tad more considered in our endorsement of those who ostensibly seem to share some of our concerns, but who either lack intellectual consistency to draw the correct conclusions from them, or who use a shared criticism of some aspects of the modern institutional setting as the point of departure for a programme totally antithetical to our aims.
In a recent article by Ambrose Evans-Pritchard on ‘The Death of Paper Money’, AEP mentioned a book on eBay which the great and the good of Wall Street and The City are reading, which is currently coming in at $699 Dollars a copy. Here’s the quote:
As they prepare for holiday reading in Tuscany, City bankers are buying up rare copies of an obscure book on the mechanics of Weimar inflation published in 1974. Ebay is offering a well-thumbed volume of “Dying of Money: Lessons of the Great German and American Inflations” at a starting bid of $699 (shipping free.. thanks a lot). The crucial passage comes in Chapter 17 entitled “Velocity”…
To save AEP’s own Tuscany holiday fund, we thought he’d like to know you can download a PDF copy of the book for free from Scribd instead, as revealed by David Kramer of LewRockwell.com.
The Cobden Centre. Always saving your money.
UPDATE:
As you may have seen, this book has now been removed from Scribd due to copyright reasons. Oh well. It was good while it lasted. I wonder what Stephan Kinsella would say about this?
The curious AEP pens another one of his strange articles which veer wildly between Austrianism and Monetarism. Despite possessing a fine mind and analysing the situation wonderfully well, AEP seems to operate on an eclectic mosaic basis, where nothing he relates through time is related to anything else. Take this schizophrenic quote from the article:
There is a clear temptation for the West to extricate itself from the errors of the Greenspan asset bubble, the Brown credit bubble, and the EMU sovereign bubble by stealth default through inflation. But that is a danger for later years. First we have the deflation shock of lives. Then — and only then — will central banks go to far and risk losing control over their printing experiment as velocity takes off. One problem at a time please.
This is the argument of the heroin addict. Let me rephrase the quote in those terms:
There is a clear temptation for me to extricate myself from the errors of becoming addicted and enjoying the pleasures of the opium poppy, by switching to methadone and other opiate substitutes. But that is a danger for tomorrow, because first I have the cold turkey shock of my life to live through. So I will continue taking the heroin to avoid that horror. One problem at a time, please.
To get off heroin you have to get off heroin and all other opiate substitutes. To get off the problems caused by too much debt and inflation, you have to stop borrowing and inflating. Yes, it will cause immediate pain. But in doing so you will prevent much more future pain and eventual economic death, through a hyperinflative depression, if you keep this habit going.
In the meantime, while AEP is busily squaring his circle and doing six other impossible things before breakfast, I thought he might want to watch this exchange between Ron Paul and the monetarist Dr Allan Meltzer, who is famous for the following phrase:
Capitalism without failure is like religion without sin. It doesn’t work.
Incidentally, in his article, AEP discusses a book on the Weimar inflation costing $699 Dollars. Fortunately, we at the Cobden Centre can recommend much better alternatives, for free:
In today’s TelegraphAmbrose Evans-Pritchard gives a splendid analysis of the dire fiscal problems facing the developed economies, but a dreadful analysis of their monetary problems.
With the UK debt to GDP ratio racing up towards 100%, there can be no serious question that the UK is approaching a fiscal precipice. The Government is indeed very fortunate to have kept its credit rating – even at the beginning of the year, one big bond investor was warning that UK Government debt was a “must avoid” as it was “resting on a bed of nitroglycerine” – but this cannot last unless the Government provides a credible plan to map the country back towards solvency.
We must also keep in mind that the ‘visible debt’, the debt on the Government’s balance sheets, is just the tip of the iceberg: when one takes into account all the hidden commitments the Government has entered into – PFI, public sector pensions, state pensions, etc. – the situation is far far worse: we are looking at debt to GDP ratios in the range of perhaps 350% to 500%.
The true fiscal situation is, thus, even more dire than Mr. Evans-Pritchard makes out. Nonetheless, he is absolutely right that fiscal expansion is not an option. Instead, the Government is drinking in last-chance saloon and it is a choice between painful spending cuts now and much more more painful cuts later.
However, Mr. Evans-Pritchard also tells us that “ultra-loose monetary is the only option for Europe, the US and Japan”. He suggests that in the US, M3 has fallen at a 10pc pace for much of this year, telling us that this was the “Great Depression rate” and so the economy hit the buffers with the “usual lag” along textbook Quantity Theory lines. The clear implication is that this needs to be reversed to get the US economy going again.
This analysis is nonsense. First off, there is no “usual lag” – Milton Friedman spoke spoke of “long and variable lags”, but most economists interpret this in the region of perhaps 12-24 months – so it is pushing it to blame very recent falls in M3 for the decline in the US economy. But in any case, the Fed discontinued publishing M3 statistics back in 2006 – one suspects, because they painted an embarrassingly expansionary picture about the true stance of US monetary policy in the bubble years.
Instead, we need to take a broader picture and look at how the monetary aggregates over a much longer period. If we do so – and lets look at the official statistics published by the St. Louis Fed on its Federal Reserve Economic Data site – we get a picture of seriously expanding monetary aggregates over a sustained period of time. Even if we look at the most recent year-on-year data we find:
St. Louis adjusted monetary base up by about 15% (though having fallen in recent months a little to $2 trillion, itself up from about $800 billion before the crisis – a big expansion in my book!);
M1 up about 5%;
M2 up about 2%;
MZM (the closest now to M3), down about 2 to 3%.
By contrast, in the early 1930s, US monetary aggregates fell by about a third.
And one should never look at monetary aggregates alone; we also need to look at real interest rates, and in this respect the difference between recent years and the early 1930s is again very pronounced. In recent years, real interest rates have been strongly negative – this of course has been a key problem, repeatedly fuelling boom-bust cycles; by contrast, in the US in the early 1930s, real interest rates were VERY highly positive, sometimes in double digits.
So the overall monetary policy stance in recent years is anything but contractionary, and there is no comparison to the 1930s.
Monetary expansion has merely created an inflation time bomb and fuelled repeated speculative cycles, the latest one being in the banking sector itself, by allowing the banks one last lending binge at negative real interest rates subsidised by the long-suffering taxpayer. Further monetary expansion would merely give the patient more of the poison that is already doing much to kill him.
Fortunately, there are solutions, but one has to think outside the washed up Keynesian macroeconomic toolbox. The reason the economy is doing so badly is because the banking system is still broken, and the economy will continue to do badly until the banking system is properly fixed. Some of us have been hammering on about this for years.
This is, I would suggest, also a matter of some urgency: the Bank of England’s latest Inflation Report suggests that CDS spreads on UK banks are rising very sharply, and are nearly as high now (200 basis points) as they were at the height of the crisis (almost 240 basis points, as opposed to a mere 10 basis points before the crisis hit). The storm clouds are gathering again for everyone to see, and no expansionist ‘solutions’ are going to help.
An entertaining article, choc-a-bloc with Monetarist whitewash, in The Telegraph today.
Apparently Jean Claude Trichet is “inflicting a triple shock of fiscal, monetary and currency tightening on a broken economy”.
Well, at least I agree with the last part. Europe’s economy is well and truly broken, thanks to a decade of loose monetary policy, low private savings, bankster socialism and the fiscal incontinence of our various Kings of Europe, but is Ambrose saying that the cure should be more of the same?
A “deflationary vortex” is what is awaiting us around the corner. Well, I agree things are bad. Monumentally bad. The plane is out of fuel (they never put enough in), and we are lurching downwards – and this is going to hurt. We are facing massive credit deflation in the private sector.
“Spiraling public sector debt precludes further Keynesian spending, so this must come from central bank stimulus.”
Uh, what? Oh please.
Let’s take a step back from all of this aggregate nonsense, and think, in clear, incisive, terms what is happening.
1. Central banks were in control of setting interest rates
2. Given low headline CPI inflation (which is a very problematic measure), policy tended to be looser than the free market would have been, and interest rates were set artificially low. (No central banker would ever keep rates a little too high – that would have risked a deflation shurely, hic, pass the punch bowl).
3. As the price of credit was set artificially low, excess credit was demanded (that bit of ‘A’ level economics, supply and demand curves, sort of work), and was happily met by the banks (thanks be to Mr. Taxpayer for all that free insurance of deposits allowing them to be lent out again and again and again).
4. People bought stuff with that credit, especially houses. Remember house price rises in 2005 and 2006 – did it seem silly or not?
5. Higher asset prices supported more credit creation by our taxpayer guaranteed banksters, which fed into higher asset prices etc
6. Something happened, depositors wanted their money back, and the spiral went into reverse
Excess private sector credit creation was the problem. The market is now trying to correct this mistake, and banks are being forced to call in credit lines that should have never been given out in the first place. Heartless some will say, but it cannot be helped. The damage was done during the period of credit creation and the resultant boom, the best thing to do, now, is to trust the free interaction of people to swiftly reallocate wasted resources from misuse towards productive use. The statist alternative is to try to mask and hide the pain, as the Japanese did in the 90’s. Look where it got them.
Now think a little about what the usually-admirably-free-market Ambrose Evans-Pritchard implies.
“Far from taking steps to offset Club Med austerity [err ‘Austerity? Shouldn’t that read ‘sanity’?] it is winding down its €50bn purchase of government bonds”
The implication here is that we should purchase more of those government bonds, all with newly-created money tokens.
Am I the only one to be horrified at the spectacle of the emperor’s nakedness here? Think about what AEP implies should be done:
1. Private sector credit is being called in, so;
2. The central bank, the guys who got it wrong in the first place, are the guys to deal with it, sooo;
3. The destruction of private sector credit (i.e. banks calling in loans to you and me) should be offset, soooo;
4. They create public sector credit via QE, soooooooo;
5. Public sector credit allows government to do more things than it should not have been doing in the first place
This credit for the purchase of government bonds does not appear out of thin air. It is funded by devaluing all of the privately held money in existence. It does nothing to sort the structural problem of business and consumer loans being called in.
The net result, after all of this, is a smaller private sector and a bigger state (unless, that is, you surrender yourself to a belief in some kind of magical process in the middle, called Monetarism or Keynesianism).
Mr. Evans-Pritchard, why are you so ardently, and happily, proposing a massive expansion of the state?
AEP is a deeply frustrating writer because although he seems capable of understanding what is happening in an almost Austrian-lite fashion — with the proviso that he needs to shift copies of The Daily Telegraph to pay his own wages — his proposed solutions are usually of the Keynesian-lite variety.
This is like being able to spot a fire at a petrol station and then to suggest that the pumping of more gasoline onto the conflagration may create such an explosion that it blows out the flames; at best, it’s wishful thinking and at worst, it is highly dangerous.
“Roughly a million Americans have dropped out of the jobs market altogether over the past two months. That is the only reason why the headline unemployment rate is not exploding to a post-war high.”
This is something that even Peter Schiff could have said on one of his radio programmes. But then AEP goes and spoils it with the following paragraph, which could almost have been sent back in time and translated from the original French by Marie Antoinette:
“It is obvious what that policy should be for Europe, America, and Japan. If budgets are to shrink in an orderly fashion over several years – as they must, to avoid sovereign debt spirals – then central banks will have to cushion the blow keeping monetary policy ultra-loose for as long it takes.”
So we cut back on government spending via the sovereign bond market and we cushion this by increasing government spending via the quantitative easing printing press? Yes, AEP really does want to have his cake and eat it.
But it gets worse:
“Perhaps naively, I still think central banks have the tools to head off disaster.”
Translation: Whatever the problem, print more money (or do the same by moving ones and zeroes around a computerised financial asset ledger) to solve it.
This one-shot solution approach to any financial problem reminds me of the old phrase about ‘The King is Dead, Long Live the King!’
The modern equivalent is ‘Quantitative Easing Has Failed, Roll On the Quantitative Easing!’
