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A Monetary Cancer Metastasizes in Europe
by Keith Weiner
The European Central Bank again cut the interest rates it controls. Notably, the deposit rate was moved deeper into negative territory. It is now -0.2% (minus 20 basis points, that is not a typo). The ECB says it’s trying to nudge prices higher, but it’s actually feeding the cancer of falling interest.
The linked article above, like most, is focused on the quantity of euros and the presumed direct relationship to price. The following bit of editorializing from that article is uncontroversial in Frankfurt, London, New York, Mumbai, or Shanghai.
“Inflation weakened to a five-year low in August, just 0.3% in annual terms. That is far below the ECB's target of a little under 2% over the medium term, raising fears that the region could face a debilitating stretch of weak or falling prices that hampers debt-financing and investment. Those fears intensified as market-based measures of inflation expectations weakened, too.”
Every assumption in this short paragraph is wrong. One, inflation should not be conceived as rising prices. There are many reasons for prices to rise or fall that have nothing to do with the currency. For example, every business is constantly working to cut costs. Without monetary debasement, and a steady stream of onerous new regulations, prices would be falling.
Two, inflation is monetary counterfeiting. Inflation is the fraud of selling a bond into the market, when the debtor lacks the means or intent to repay. The deadly danger is that it seems good to creditors who buy it, often using leverage. Eventually, every fraudulent debt will default.
Three, central banks keep trying to engineer rising prices, in the name of some sort of good, like Stalin and his Five Year Plans. The economic theory that demands this is frivolous at best. There is no there, there. This does not stop the central planners from trying their worst anyway.
Four, it should be obvious by now that central banks do not have control over prices. If they did, we would not still be struggling with prices that stubbornly refuse to rise. How many times has the ECB tried to get prices to rise since the last acute phase of the monetary crisis?
Five, falling prices do not hamper financing or investment. Look at the massive investment in first electronics, then computers, then computer networking, and most recently communications. Prices have been falling, for a long time and by a large amount even in nominal dollars.
Finally, we must distinguish between the prices of consumer goods and the prices of assets that are bought with leverage. The latter is a threat to those who borrow short-term to finance long-term assets. For example, when a real estate developer sells 3-year bonds to buy a large commercial building. Since the developer can’t amortize the debt in three years, it will roll its liabilities—sell new bonds to pay off the old ones. This is a form of counterfeit credit. One way to get in trouble is if the market value of the property falls. Then the bonds cannot be rolled.
These are some of the errors in the conventional, quantity analysis approach. It’s the wrong approach, though it seems intuitive. Suppose we think about wheat. We consider if we had ten huge bags of grain how would we feel if a truck pulled up to attempt to deliver the 11th. Or if we had a basement full of copper bars and contemplated buying more. No one wants to bury himself under a hoard of useless stuff.
Money is not like any commodity. No matter how much money we have, the thought of receiving a big check in the mail is exciting. We don’t think we have too much money already. Even the most die-hard gold bug, is eager to sell you his newsletter in exchange for dollars. No one rolls his eyes or sighs at the prospect of making more money.
We cannot assume that a rise in the money supply translates into a rise in prices. It might or might not. However, there is a danger in focusing too much on prices, and missing the terminal monetary problem. Imagine a doctor obsessing over a patient’s body temperature. He could easily miss the signs of cancer.
I saw a different approach in an article this week. The author suggests that rates on government bonds are now negative, because investors trust they will get their money back. Presumably, this school of thought regards the US government as less trustworthy because the Treasury bond pays a higher yield. This approach is also wrong.
Let’s take a look at the yield curve in Germany.
There is a reason why the yield on government bonds in Europe is falling to zero and below. Banks have a choice to hold cash or government bonds, with the main factor being liquidity. However, when the ECB lowers the deposit rate for bank cash to below zero, this changes the incentive. The lower the yield on cash, the more the banks will tend to prefer bonds.
I am no European political expert, but perhaps this is the intent of the ECB. Perhaps they would simply like to buy more government bonds, but cannot or dare not due to treaty, law, or politics. But they clearly have the power to create incentives for banks to do it.
The right approach to understanding what’s happening in the euro begins with the observation that a paper currency like the euro is a closed loop system. You may think that you can protest a negative interest rate by getting out of the currency. For example, you can buy antique Ferraris, paintings, real estate, stocks, a foreign currency, or even gold. This may protect you personally, but it does not alter the trajectory of the interest rate.
The former owner of the asset is now the owner of those euros. What will he do with them? Deposit them in a bank. What will the bank do? Buy a bond. At one time, all roads led to Rome. Today, all monetary roads lead to the government bond that backs the currency.
We are all disenfranchised by the regime of irredeemable money. The central bank may have some control. Or, as I argue in my theory of interest and prices, they have little control but set up a positive feedback loop that drives interest to zero. However, the people have no control. The rate has been falling for decades, pushed down by massive forces beyond even the control of central banks. The price of the bond, and hence the interest rate, is set free from constraint.
Consider for a moment, the price of wheat. If the price falls below the cost of growing, then farmers stop planting it. Alternatively, if the price rises above that of other starches, then manufacturers will stop buying wheat. The cost of wheat and every other real thing is dependent on the price of oil, machinery, labor, and many other inputs, it is tied to everything else in the economy.
By contrast, the bond price in a paper currency is not tied to anything. It could collapse and give us an interest rate of 17%. Or it could have a 33-year bull market, and give us an interest rate below 1% (the bond price is inverse to the yield). The rate can keep falling.
There is a cancer metastasizing in the body economic. Zero interest is creeping out from the short-term credit facilities provided by central banks. In Germany, it is now out to the 4 year bonds. Zero interest on overnight deposits is like gangrene in your fingernail. When it hits the 1-year bond, it is spreading to your whole finger. The 2-year bond is like the lower part of the hand. The German 3-year bund now has a negative yield. The all but zero-yield on the 4-year bond is like rot moving up towards your elbow.
What will they do when necrosis spreads up to the shoulder and beyond?
We need a new concept to understand the nature of the problem. The burden of debt is
a measure of the pressure on debtors. The net present value of a stream of future payments depends on the interest rate. This is not just the interest rate at the time the asset was purchased. The present value should be recalculated whenever the interest rate changes. Each time the interest rate falls the net present value rises.
This seems good for the bond speculator, who gets a capital gain. However, this is a zero sum game. His gain comes at the expense of the bond issuer. The bond issuer feels an increase in his burden of debt as rates fall. With each halving of the rate of interest the burden doubles. Of course, the falling rate is also an incentive to borrow more, because the monthly payment is lower. Debtors owe more euros of debt, and the burden of each euro owed is doubling. Here is a graph of the history of the German 10-year bund, a reasonable way to measure burden of debt.
In June of 2008, the 10-year bund yielded 4.5%. This is labeled point 1. By August of 2010, point 2, the rate was cut in half to 2.25%. The burden of every debt in Germany—and arguably Europe—doubled. In July of this year, it was lopped in half again to just about 1.13%, at point 3. Now it is 0.94 and well on its way to the next milestone of 0.56%. Not coincidentally, Japan is already there.
This burden of debt is one of the most important concepts, because the entire basis of the system is debt. One man’s debt is another’s asset. The ultimate asset is the debt of the government. If debtors begin to default in earnest and if one default causes others in a cascade, then the system can collapse like dominoes.
The analogy of dominoes is apt because creditors are themselves debtors. They are typically leveraged, so a small loss can cause insolvency.
The financial system must collapse—necessarily so—when the interest on the long bond hits zero. Debtors cannot hold up an infinite burden of debt, and that is what a zero long-term rate means.
Consumer prices in Europe may continue to eke out small gains, especially as the carry trade begins to press down the value of the euro compared to the dollar. Or prices may begin to fall, perhaps slowly.
Either way, who cares? The patient’s arm is turning black.
The Gold Standard Institute Presents The Gold Standard: Both Good and Necessary, in Manhattan on Nov 1. You are cordially invited to join us for a discussion of ideas you won’t get anywhere else. The gold standard is the monetary system of the free market—of capitalism. Dr. Andy Bernstein, a rock star of the liberty movement, shows why capitalism is good. In my talk, I explain why capitalism is impossible with fiat money, and why we have not recovered from 2008, and we won’t without gold.
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http://www.safehaven.com/article/12584/growth-and-debt-is-there-a-trade-off
Cancer grows.
Negative interest rates stop and or reverse growth.
Negative interest rates are the chemo!
Gold backed? Real money?
I'm sure Keith is a nice guy but it's gonna take more than a debt collapse and massive fiat devaluation to restore a money system back to a gold standard of some sort.
There's too much advantage for central banks and govt.s counterfeiting 'wealth' anytime they choose by credit to be bound by a rational system of value where credit consists of savings and has a real cost.
It's like sending a note to the Mafia asking them to give up crime.
Or expecting Congress to abide by the Constitution and do their job while suffering the loss of significant campaign funding.
Some changes can only take place under a threat of an imminent lead delivery.
It may be the reason they're stocking up so much of it. Nobody uses hollow points to 'practice or 'qualify'. Hollow points have only one function.
One.
Bills of credit denominated in gold bullion, a clearing system similar to what the world had before WWI.
"One, inflation should not be conceived as rising prices."
no, but the only mandate of the ECB is price stabilty, through an elastic supply of liquidity and other means. it can't hide (like others) behind the fig leaf of "doing it for the employment"
while I agree on some aspects of this article, the real question imho is this:
which kind of currency leads to repayment of debts? and which kind of currency leads to an escalation of overindebness?
my answer - based purely on historical empirical evidence - is that a soft currency is a debt trap, while a hard currency less so
inversely, a soft currency gives the impression of making debt more easily repayable. but eventually, higher rates kill that dream, through compounding
"repayment of debt" -- Considering the amount of debt in the earth's financial system I have to LMFAO!!!
Sorry, we are here (again)---> "The great questions of the day will not be settled by means of speeches and majority decisions but by iron and blood." - Otto Von Bismark
Laws, I'm not talking about the big mountains that are not meant to be ever repaid, just carried along, but in general
to put it in a different way: would gold make mortgages more or less likely to be carried and eventually be repaid successfully? my answer is... more
"How does the debt get created in the first place" and let me answer that for you: " Wall Street."
It's not the bonding but taxing authority that is at risk here. You have to have growth...employment, jobs, income...and this requires HONESTY. "The payment mechanism is actual payment." When prices collapse the debts become unpayable/unplayable. When you back your money with gold it's simply impossible to create levels of debt of this magnitude.
The guy who has the gold wants his MONEY back...not "his" (meaning your) debt.
Eddie Lampert is a good example: he simply destroyed all the bond holders and created a new class of shareholders called "him." The law never said a word.
General Motors is another one. "The law itself said too bad if your a bond holder." That says to me if you ever want to see your money again you have only three options: cash, equities and treasuries.
Everything else is a fraud.
You can produce enough energy to basically make it "free" (in the sense of available to every human on earth)...that in and of itself does create "liquidity" in its own right (like a Government) as it creates demand for many other things. (Clothes, housing, more energy.)
Unlike a Government it does not tax or devalue "you" ( meaning your labor) as well. And of course there is always the "Government rate."
Ghordis, my point was that debt is irrelevant now. Factories around the world run on calories available for consumption, period. It takes such calories to refine PMs.
The "global currency" is anything containing such calories.
This is bubbling to the surface all over the world, hedge accordingly.
"I am no European political expert, but perhaps this is the intent of the ECB. Perhaps they would simply like to buy more government bonds, but cannot or dare not due to treaty, law, or politics. But they clearly have the power to create incentives for banks to do it."
politically, they are expected to create incentives for banks to buy sovereign bonds, and they do. you could say it's a tradition, and in older bad times it was not unusual to find banks stuffed up to the gills in them. after all, the ECB is a confederation of national banks with a long history of treating their national banking systems in the same way as Emperor Vespasian treated his "financial" knights 2'000 years ago
The "emperor" spoken again
http://failedevolution.blogspot.gr/2014/09/the-emperor-spoken-again.html
Euro strength will soon be restored thxs to technology finally catching up. A new wireless device will link our European peasant/goyim blood directly to the squid ecb.
NB I selected the word 'squid' to be a strikethough. It shows as struck through before posting. Thank you.
ECB President Mario Draghi's last move towards more QE is no more than stupidity on steroids, even words like misdirected and boneheaded do it a disservice. This is more proof that the Euro-zone is in big trouble, both the union and the flawed currency is again begging to crumble.
One is forced to wonder if Japan and the Yen will crash first considering how each day Japan slides closer to the economic abyss or whether the Euro will lead the way into the wastebasket. More on how the Euro-zone and its lack of action in the article below.
http://brucewilds.blogspot.com/2014/09/euro-zone-and-draghi-both-mired-i...
Why don't they just admit the debt can't be paid, restructure, let prices fall to match their market clearing level and get back to work?
musical chairs I think, at least on some levels.
On other levels, its that scene in the original Italian Job, when they're all standing in the bus that is teetering on the edge of a cliff, seeing if Michael Caine can shimmy far enough to retrieve the gold, and save their heist, otherwise they all die. Pictures below.
http://www.dailymail.co.uk/tvshowbiz/article-1090136/Hang-minute-Ive-got...