Plan A

In its most recent monetary policy announcement, the ECB council introduced a new type of long term financing instrument, the so-called “TLTRO”, short for “targeted long term refinancing operation”. The reason is that the ECB has noticed that in the wake of its frantic – and ultimately successful – attempts to dissuade the market from punishing what are de facto bankrupt governments (there are only very few governments left in the world that are not in actuality bankrupt entities relying on a Ponzi finance scheme), lending to the private sector has plunged.

Let us recall the events surrounding the crisis. Beginning with Greece, Portugal and Ireland, it was suddenly realized that a number of governments in the euro area were actually on the brink of insolvency. The reasons were varied: in Greece, an inept and corrupt political and bureaucratic apparatus had for many years lied about the true state of the government's finances. Everybody in Brussels knew of course that they had been lying. After all, they were already lying when they joined the euro, and a number of economists and a handful of conscientious Brussels bureaucrats alerted the European commission to this fact. It was decided to simply get rid of these critics by firing them, so as to proceed with a cover-up. However, this scheme obviously unraveled with the advent of the crisis.  In Ireland, the government had made the mistake – under pressure from various European institutions – to bail out its overextended and insolvent banks and in the process bankrupted itself.

From these humble beginnings (“the problem is well contained” was the widely heard refrain at the time), the crisis began to flower and soon included a few rather large, and partly “too big to bail” candidates, like Spain and Italy.

In the course of all this it was also discovered that Europe's fractionally reserved banking system – surprise! – had flagrantly overtraded its capital and was completely insolvent as well. “Luckily” though, we have a fiat money system and a central bank, which means that the losses of banks and governments can be “painlessly” shifted onto the backs of savers and wealth generators in the economy via the printing press. After all, the US Federal Reserve had already shown the way (as had incidentally Japan some time earlier already).

But in the euro area there is a problem: since the central bank is a supra-national entity, there is an incentive for deadbeats to go on doing what they are doing simply because the losses they produce will actually be shifted to the tax payers and savers of other nations. This is why it took so long to come to a consensus and why the European solution actually included a measure genuine pain for a number of the worst offenders, or rather, pain for the citizens of these countries. The political and bureaucratic elite suffered no consequences at all, except for politicians who intended to break with the consensus and threatened to upend the “European Project”, such as Silvio Berlusconi. Apart from that, the State has continued to grow everywhere. 

In late 2011, the main problem was that both the Spanish and Italian governments were on the brink of becoming the next Greece: yields on their government debt exploded, as the market doubted that the ECB would bail them out (it should be noted that in reality, a massive 'stealth' bailout was already underway via the TARGET-2 payment system, which was used as a valve to replace private funding of current account deficits with central bank credit).

Italy, 2 year government bond yield – click to enlarge.

In one of the many emergency summits in 2011, the former president of France, Nicolas Sarkozy, inadvertently let slip what the solution was going to be: why not use Enron to prop up Worldcom? In other words, why not use the insolvent commercial banks to prop up the debt of insolvent governments by providing the banks with the necessary central bank funding? We have little doubt that there were sub rosa agreements made to the effect that the ECB would release LTRO funding for all sorts of toxic crap that was imbued with “government guarantees” by insolvent governments, and that the banks would in turn use the funds to buy the debt issued by the very same governments.

TARGET-2: the “stealth bailout” – click to enlarge.

Why else would they have done it? After all, nothing had really changed fundamentally to suddenly make the government debt of Italy or Spain “safer”. However, the bureaucrats had come up with another idea. After realizing that any talk that hinted at the fact that government debt is actually risky would only deepen the downward spiral, it was decided that all government debt, no matter how dodgy, was actually going to remain a “zero risk” asset for the purpose of determining the regulatory capital buffers of banks. 

This trick is actually – at least in spirit – a variation on the trick used in the US in early 2009 to transform the financial situation of insolvent fractionally reserved banks overnight. In the US, mark-to-market accounting was repealed, which made it possible to alter the value of worthless and illiquid toxic crap for accounting purposes. Suddenly, insolvent banks looked “healthy” again.

It was clear that banks in Europe would have to raise capital and take various measures to improve their balance sheets – at the same time however, it would not do to make it impossible for them to continue to buy government debt. The major privilege enjoyed by banks – namely their ability to create money ex nihilo by means of fractional reserve lending – has historically always been predicated on the fact that the banking system is joined at the hip with government. In return for the privilege that allows banks to appropriate wealth by what is really a fraudulent activity (fractional reserve banking presupposes that two or more different parties can have a claim to the same funds, which should be impossible under a system that respects property rights), they are expected to scratch the backs of governments by funding their debt. Historically this arrangement has come about due to the need to finance wars via the “inflation tax”, as it would seriously crimp the war-making abilities of governments if they were forced to fund wars by other means (such as raising taxes) than in this surreptitious manner.

As a result,  government debt continues to be regarded as a “risk free asset” in the regulations governing the risk weighting of assets, which stipulate what capital reserves must be put aside by banks to “back” their risk exposure (i.e., Basel III and the associated rules issued by the EU commission and the ECB in Europe). We may consider this part of “Plan A”, which was all about rescuing the government debt Ponzi scheme.

Plan B

However, in their eagerness to institute measures of credit dirigisme that would rescue insolvent governments, the planners overlooked that there would be side effects. Since there was a need to restore confidence in the banking system as well, capital adequacy rules were tightened. Various “stress tests” were performed as well, which went from totally ridiculous propaganda exercises with zero credibility or practical value (the bank that was declared the “best capitalized” in all of Europe, DEXIA, went bankrupt just four months after the first stress test had concluded it was in ruddy financial health) to somewhat more sophisticated exercises that still serve mainly as propaganda tools, but are at least slightly more credible.

However, as noted above, the flow of bank credit to the private sector has actually declined, along with a vast increase in government financing by commercial banks. In several countries, this appears by now rather odd. For instance, a bank in Italy can earn about 1.8% by lending money to the government, but it could earn well over 5% by lending to a medium sized company. So why isn't the flow of credit reversing?

For one thing, there is of course a lack of credit demand. However, the main reason are probably precisely the regulations regarding the risk weighting of assets that were explicitly designed to support government debt at the expense of other credit demanders in the economy. Ned Davis Research recently showed an arithmetic example that explains this effect in detail:

“Let’s illustrate this bizarre arithmetic with fictitious Bank Europa. Bank Europa has €30 in tier 1 capital and €300 in risk-weighted assets, for a tier 1 capital ratio of 10%. Bank Europa also pays a dividend of €1.5.

Bank Europa is considering two invest­ments, each worth €10: a five-year note from the Republic of Italy at a 1.8% yield or a five-year loan to an unrated Italian corporation at a 5.6% yield. Since Italy is a member of the OECD, its bonds carry a 0% risk weighting. On the other hand, unrated corporate loans carry a risk weighting of 100%.  

Assuming no default and zero-cost funding, the sovereign bond will contrib­ute €0.18 (10*1.8%) to Bank Europa’s net income, which will allow the bank to raise its dividend to €1.68. Because the bond is treated as risk-free, Bank Europa’s tier 1 capital ratio remains 10%. 

The corporate loan would contrib­ute €0.56 (10*5.6%) to Bank Europa’s net income. But it would also increase risk-weighted assets to €310. Bank Europa needs to retain 1 additional euro in earnings to maintain its tier 1 capital ratio at 10%. As a result, it can only afford to pay out:  1.5 + 0.56 – 1 = 1.06  (old dividend + gain on corporate loan – extra retained earnings)”

As Ned Davis explains further, since many of the largest investors in Italian bank stocks are foundations and trusts that depend on the dividend income they receive from their investments, there is an extra incentive for banks to invest their funds in a manner that ensures that such dividend income is secured, resp. keeps growing. So even though it would make a lot more business sense to fund the private economy, financing government at paltry yields continues to be preferred – ironically, in spite of the fact that Italy's government continues to drown in debt (although to be fair, it is in far better shape than most European governments in terms of its unfunded liabilities). As a result, bank lending in Italy looks like this:

Bank lending in Italy: the red line shows outstanding loans to the private sector (corporations), the blue line bank assets in the form of loans to the government and government bonds – click to enlarge.

And this is the reason why new credit dirigisme measures have now been announced by the ECB – to “fix” the unintended consequences of previous interventions, new interventions are undertaken. This is what we may refer to as “Plan B”. Will it work? In light of the above, probably not.

It is of course a good thing that the expansion of inflationary fractional reserve lending has been crimped – today, only 30 cents in new lending support every euro in GDP growth, as opposed to 1.1 euro in fresh lending per euro of GDP growth previously. One effect is that there is a brake on capital malinvestment due to the expansion of credit to business.

However, since at the same time, lending to governments has been vastly increased, malinvestment simply arrives through this avenue, and will tend to be intra-temporal rather than inter-temporal in character. Governments consume most of the funds they receive, and if they invest, these investments as a rule support projects that are not economically viable, such as e.g. various “green energy” subsidies. The beneficiaries are the government cronies who are most experienced at feeding at the tax payer trough and employ the most efficient lobbyists. Practically all of this funding ends up supporting malinvestment.

It is no different when governments fund other types of “infrastructure” – since there is no way for them to engage in economic calculation, they have not the foggiest idea about the opportunity costs involved. They simply cannot know if the resources spent on specific infrastructure projects may not have been needed more urgently elsewhere in the economy (as a rule of thumb it can be assumed that most of these investments are likewise misallocations).

Lastly, due to the accounting procedure used to calculate GDP, the waste of scarce capital that most government spending represents actually appears as “growth” in the national accounts, whereas it should really appear under the heading “waste”. Hence the above back-of-the-envelope calculation regarding the amount of credit growth per euro of GDP growth is actually flawed as well, since a large portion of so-called GDP growth is not really economic growth at all, at least not if one interprets the term growth to mean an actual increase in society's real wealth.

Conclusion and Plan C

Similar to other government interventions, credit dirigisme will always have unintended consequences. The authors of such interventions pursue mainly their own interests of course, but even if we were to take them at their word and believe that their activities are chiefly designed to increase the general welfare of society, they are bound to fail in achieving this goal.

The only long term solution that promises lasting improvement is a return to free market principles, which in the case of the banking system means the institution of a free banking system that respects property rights.

We may term this “Plan C”. Unfortunately, none of us may live to see its implementation.

Charts by: bigcharts, IFO Institute, ECB/Ned Davis Research