Giving Birth to a NIRP Egg

As readers may know, Mario Draghi's surname is in fact the Italian word for dragon. We sometimes wonder if David Icke knows about that…well, not really actually.  Anyway, shortly after Thursday's bizarro, but not exactly unexpected ECB decision, we came across the following headline at Reuters:

“ECB cuts rates below zero to buoy euro zone economy”

Luckily we weren't in the process of taking a sip from a cup of coffee or engaged in any other spillage-prone activity at that moment. The headline might as well be the title to a Monthy Python skit. Apparently the Dragon (whom we refer to as Jabberwocky above, in line with the Monthy Python association) has laid precisely the kind of egg he was widely expected to lay. The ECB has “given birth to a 'mini-NIRP'”, as a friend helpfully pointed out to us.

We  expected no less. However, as we have relayed in some detail over recent weeks, these newest policy initiatives make as much sense as screen doors on a submarine, which is what makes the Reuters headline so Pythonesque. Not that we have any 'better' ideas to offer, except instituting a free market of course (no central banks needed). 

“ECB cuts rates below zero to buoy euro zone economy”? Say what? How in tarnation is a 10 basis points penalty rate on bank excess reserves going to “buoy the economy”?  Maybe they are thinking of a Jabberwocky type small cause, big effect chain?

How to increase efficiency, Jabberwocky style – or small cause, big effect.

However, it later turned out that 'NIRP' (negative interest rate policy) was not all. Reuters clarified that “ECB hurls cash at sluggish euro zone economy, says not done yet”.

“The European Central Bank cut interest rates to record lows on Thursday, launched a series of measures to pump money into the sluggish euro zone economy, and pledged to do more if needed to fight off the risk of Japan-like deflation.

For the first time, the ECB will charge banks for parking funds at the central bank overnight in an attempt to force them to lend to small- and medium-sized businesses.

The measures were also aimed at easing pressure on the strong euro, which is threatening economic recovery and importing disinflation.”

(emphasis added)

With respect to “easing pressure on the strong euro”, the measures – luckily for European citizens – seem to have failed for now. As we have often pointed out, one cannot devalue oneself to prosperity. A strong currency is a good currency; it makes imports cheaper and consumers will accordingly be better off.

At first, the euro came in for some selling – then it reversed course rather convincingly, via StockCharts, click to enlarge.

A Long List of Threats

What else has the Dragon threatened holders of the euro with? After all, the central planners are now in the icy grip of deflation paranoia (God forbid that consumers may actually get to enjoy falling prices one day – that would be terrible!). So the birth of 'NIRP' was accompanied by a plethora of additional interventionist threats.

“The bank stopped short of full-fledged quantitative easing (QE) – printing money to buy assets – but ECB President Mario Draghi said more action would come it necessary. Asked why the ECB had not gone ahead with QE, he told a news conference:

"We think (what we've done is) a significant package. Are we finished? The answer is no. We aren't finished here. If need be, within our mandate, we aren't finished here."

RBS economist Richard Barwell said this comment would fuel market expectations for more action: "We doubt the knee-jerk response to further bad news will be 'give the June package more time'; expectations of a broad-based asset purchase program will rapidly start to build," he said.

Draghi outlined a four-year 400 billion euro ($544.86 billion) scheme giving banks that have been holding back credit due to looming stress tests an incentive to increase lending to businesses in the euro zone.

"Now we are in a completely different world," Draghi said, citing "low inflation, a weak recovery and weak monetary and credit dynamics". The package, adopted unanimously, was aimed at increasing lending to the "real economy", he said.

Other steps included extending the duration of unlimited cheap liquidity for euro zone banks, injecting about 170 billion euros by stopping tenders that withdrew funds spent on past government bond purchases, and preparing for possible future purchases of asset-backed securities to support small business.

Projections published by the ECB showed inflation would be just 0.7 percent this year, 1.1 percent next year and 1.4 percent in 2016, a downward revision and far below the ECB's target of below-but-close-to 2 percent.

"If required, we will act swiftly with further monetary policy easing," he said, adding that the policy-setting Governing Council was unanimous in its commitment to use unconventional instruments if needed "to further address risks of too prolonged a period of low inflation".

(emphasis added)

First of all, the countries in the euro area in which prices are currently ever so mildly declining, need falling prices.Factors of production have been severely mispriced in these countries during the boom. The process of repricing, which if left to proceed unhindered would quickly restore balance in these economies and reflect the true state of the market, is both necessary and beneficial.

The ECB continues to interfere with this process. Hasn't the downturn already taken long enough? Why implement measures that will only make it worse by stretching the process out even further?  Moreover, low inflation is not a 'danger', it is a boon. Oh well, at least central banks are no longer pretending to be 'inflation fighters'. This absurd propaganda, which has for many years painted the very founts of inflation as 'inflation fighters', is apparently gone for good. 

We should also comment on the other schemes, aimed at enticing banks to 'inject credit into the real economy'. Many banks in the euro area are actually not as reluctant to lend as they are made out to be. The fact is that there is very little credit demand, and what demand there is comes mainly from borrowers that are not creditworthy. These borrowers are charged higher interest rates in order to properly account for the risk they pose to creditors. Nothing the ECB does can alter this fundamental principle.

If certain banks have indeed held back credit due to the looming 'stress tests', that obviously means that they are capital challenged and should in fact not expand their lending. If they cannot survive a 'stress test' after expanding their lending, then they will obviously be in breach of their fiduciary duties to their depositors as well as their creditors if they go ahead anyway.

Lastly, Draghi and his fellow central planners seem to proceed from the assumption that what limits credit in the economy is 'money'. This is patently not the case. After all, nothing can stop commercial banks from expanding deposit money created from thin air: there are already massive excess reserves, the required reserve ratio is at a laughable 1%, and the ECB has long agreed to accept all sorts of toxic trash in its refinancing operations.

In reality, the limit to credit is ultimately given by the scarcity of capital and the economy's pool of real funding. If it were not so, then the economies of Zimbabwe, Argentina and Venezuela would have thrived as a result of their central banks letting the printing presses work overtime.

What we are saying is this: the expired boom, which the ECB's previous loose policies aided and abetted, may have resulted in so much capital consumption that there is now literally 'nothing left to lend' in some regions. If banks were to expand credit under these circumstances, they would only run the risk of adding to the bad loans on their books. Unless the real resources needed to expand production actually exist, injections of new money into the economy will not achieve anything, not even from the point of view of those who erroneously believe that inflation creates prosperity. If the economy's pool of real funding is exhausted, then there won't even be anything that can be misdirected into new bubble activities.

Under these conditions, the economy's production structure must perforce be shortened and new savings must be accumulated before one can think of expansion again. In other words, what certain economic regions in the euro area lack is not 'money', it is genuine savings. The ECB's policies meanwhile are only making life more difficult for savers, by denying them a reasonable return.

Conclusion

If the euro area's economy revives, it will do so in spite of the ECB's interventions, not because of them. A lot of malinvested capital has already been liquidated, in spite of the obstacles erected by loose monetary policy and numerous government interventions to date.  There is no need to fear 'deflation' (the euro area's money supply continues to expand, so there is no genuine deflation anyway), and forcing banks that are short of capital to endanger their depositors and creditors by expanding their inflationary lending makes no sense whatsoever. What the euro area needs is not a faster expansion of circulation credit, what it needs is an expansion in genuine savings. If the ECB wants to support economic recovery, it should abandon its fruitless activism, which can only create even more distortions.

Mario Draghi: just you wait, we shall bury you in more money from thin air.

(Photo: AP)