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The State of the Global Markets 2015

Euro Crisis, Central Bankers Dream of Economic Decoupling

Currencies / Euro May 08, 2010 - 06:57 AM GMT

By: Michael_S_Rozeff

Currencies

Best Financial Markets Analysis ArticleIt begins with government fiat. Money is mostly electronic. It is mostly "e". It is mostly a series of 0s and 1s in memory banks. Everyone by fiat must accept e-money in payments. It is made into legal tender.

We live in a world of central banks and fiat money. Central bankers are at the core of one portion of a larger government-created political economy. They are the department given the power to create and destroy the electronic bank reserves of ordinary banks. These reserves are nothing more than an e-credit asset account in an ordinary bank's computer memory and an offsetting e-liability account in the central bank's hard drive.


Mostly the central banks create, not destroy, these electronic credits or e-credits. They will turn some of these e-credits, upon demand from the ordinary member banks (retail banks), into hand-to-hand currency printed for them by a treasury department of the government. Mostly the credits issued to banks stay in a member bank's computer as electronic bank reserves.

Central banks are wholesalers of e-credits called bank reserves, but they are unusual wholesalers. They supply bank reserves almost free of charge to member banks, but within mysterious quantity bounds that they appear to determine on their own but really don't; for they are downstream from forces that impinge upon the extent of their e-credit operation. They seem to be independent, claim to be independent, but are not independent. They are part of a larger system.

The central banks are not much more than the hands that decide when and how much to buy or sell, usually of government debts, thereby revving up, slowing down, or even putting into reverse their e-credit printing press. They are a stage in the supply side of modern fiat money. There are brains behind the hands.

Downstream are the retail banks that keep track of these e-credits in a small portion of their hard drives. Given a supply of these zeroes and ones, the retail banks are able to let loose e-credits of their own. These are the credits we call demand deposits or money or bank money.

Ordinary folks get into this game by creating their own IOUs, which are also e-credits, in exchange for the bank money. These are loans of all sorts, including subprime mortgages.

The central banks won't give the ordinary banks anything concrete in return for their e-reserves. They are not redeemable except to cancel out IOUs. The ordinary bankers will not give anyone who delivers an e-credit to them anything concrete in return either. It either cancels out an IOU or else it goes into the bank's hard drive as an e-credit. People can self-redeem e-credits by buying goods and services with them, as long as they find someone willing to accept them. Since the e-credits are legal tender, they are usually accepted - at some price. The prices of goods and services (anything that can be bought and sold) equilibrate the supply and demand of the e-credits.

The assets of retail banks are mostly IOUs in the form of e-credits. Their liabilities are mostly more e-credits. Banking is thus a relatively clean business that involves mostly zeroes and ones inside hard drive memory banks, a fit name for them.

Reality occurs at this juncture. Persons in the public who sign the IOUs are expected to expend energy and work in order to obtain enough bank money e-credits from other people so as to cancel out their e-credit tallies at the retail banks.

Governments who sign the IOUs are expected to tax the public so as to obtain enough e-credits so as to cancel out their e-credits from whoever has granted them such credits. They rarely clean up their credits, however. Mostly they roll them over. They keep them in the hard drives more or less permanently, but they are expected to maintain a flow of e-credit payments known as interest on the principal amounts outstanding. The e-principal is merely a partial 0-1 signifier of how many e-credits they are expected to pay as interest, the other part being a rate of interest.

In this system, central bank e-credit inflation is a very simple matter. Create more central bank e-credits from nothing by buying any asset in the world. Mostly the central banks buy government debts. Downstream, the retail banks have the power to inflate their own bank money e-credits by making loans. The public and the government together have the power to bring these bank money e-credits into existence by agreeing to issue their own e-credits in the form of debts or IOUs to the retail banks. Jointly the retail banks and the public simultaneously create IOUs and bank e-credit money.

Upstream from central banks is government. They pressure their central banks to issue more e-credits, sometimes directly to them rather than through retail lenders. This pressure upon central bankers is a political-economic demand side pressure. This is where the action is: the demand that stems from the governments that have created their e-money subsidiaries.

Yet, strangely, there are central bankers who dream of decoupling from the dynamics of this system. That's what all the talk of their independence is about. That's what inflation targeting is about. They actually think that they can manage fiat money independently of the fiscal measures and demands of their governments.

There is no longer a metallic standard, silver or gold, but there are central bankers alive today in the middle of this system who do not understand their position. They actually think that they can create a Trichet standard or a Bernanke standard or a commodity basket standard or a consumer price index standard. These 19th century dreamers, who hope to replace metal money with their professionally-managed fiat money, don't seem to realize that they are caught in a 20th and 21st century fiat money web. They think they can decouple from the fiscal shenanigans of their governments. They actually parade down to their parliaments and legislatures and lecture them on getting their budgets in order.

Are they anything but dreamers? Who has the upper hand? Who will win the battles between the monetary and fiscal authorities? Does the man with the open-market operation, who is appointed by his nation's leader, think that he can long resist what that leader wants him to do? Does anyone seriously believe that the President does not choose a head central banker who will do his bidding? What central banker has ever seriously or for any length of time managed to thumb his nose at his nation's chief executive?

Let us quote an article written by Ambrose Evans-Pritchard:

"Jean-Claude Trichet, the ECB's president, said the bank's governing council had not even talked about a possible purchase of eurozone government debt at a meeting in Lisbon, despite pleas from economists that this may be the only way to prevent the crisis spiralling out of control.

"'We did not discuss the matter. I have nothing more to say on it,' he said. He stressed that the ECB is 'inflexibly attached to price stability', even though core inflation is near record lows at just 0.9pc.

"'Governor Trichet came very close to saying that the current mess is not the ECB's problem,' said Lars Rasmussen from Danske Banke."

The ECB is a political-economic institution. Its mandate is price stability. There has been price stability in the price index the bank uses. At the same time, the ECB's balance sheet has been anything but stable. At the end of 2003, banknotes outstanding were 439,206 millions. At the end of 2009, they were 807,191 millions. This is an increase of just over 10 percent a year, continuously compounded. There is clearly something amiss with inflation-targeting if it results in a monetary inflation of this size, especially when real economic growth in the EU since 2003 has been about 1 percent a year.

If someone were presented with the ECB balance sheets with the name removed, they would be hard put to tell it apart from the balance sheets of many other inflating central banks. No matter what the mandate is and what the price index inflation has been, the ECB has responded to something as reflected in its expansion of e-credits. Its balance sheet has grown at a high rate.

Mr. Trichet may not want to see an even higher rate of growth, but the main point here is that he is far from being in a condition of independence. He may dream of decoupling from the fiscal pressures in which he is immersed, but he cannot. Monetary operations of central banks are joined to fiscal operations of the governments that create them. That is why they are created.

It seems that market participants know this. They know how the fiat money game is played. The name of the game is inflation in e-credits. The name of the game is bailouts. There is no such thing as stable fiat money. If governments wanted that, they could have a central bank with one employee who would hold the Milton Friedman chair. He would issue 2 percent more e-credits each year, never more, and never less. This is not the game. It is when the central bank stops playing the game or threatens to stop playing the game that markets get rattled and tank.

"The ECB's paralysis in the face of severe credit stress rattled credit, equity, and currency markets across Europe. The euro crumbled to a 14-month low of $1.27 against the dollar and BNP Paribas said the currency to reach parity by early next year.

"Spreads on 10-year Portuguese bonds rose to a post-EMU high of 329 basis points (bps) over German Bunds, and rose to 296bps for Ireland, 150bps for Italy, and 148bps for Spain."

"It is the first time in this crisis that Italy has started to flash warning signs. Bank shares plummeted in Milan, with falls of 10pc for Unicredit and 8.6pc for Mediobanca."

The markets expect Mr. Trichet to behave himself and inflate:

"Gabriel Stein from Lombard Street Research called Mr Trichet's remarks 'embarrassingly meaningless' and said it was hard to believe that the ECB had not discussed a move to quantitative easing. 'Either the governing council is guilty of gross dereliction of duty, or the ECB is treating journalists and analysts as ignorant children,' he said, echoing a view widely held in Europe's financial centres."

We, at least I, am gradually discovering the day-to-day political-economics of a fiat system. It seems that in its advanced stage, which we seem to be in, it goes into a state of permanent "emergency" in which more and more e-credits (called "liquidity") become essential to its survival. The trigger for this is defaults on debts from anywhere in the system. Since the expansion of e-credits is always accompanied by the expansion of loan e-credits, there is a tendency to create far too many e-loans, many of which turn out to be bad loans. That triggers the emergency. The power of the central bank to create bank reserves ad libitum and the power of the governments to borrow and the profit motives of the banks who grant loans all combine to produce an untenable political economy.

The fiat system is hooked on e-credit expansion:

"Mr Stein said the ECB had allowed the M3 money supply to contract over the last year, raising the risk of a slide into deflation. 'It is no coincidence that the Greek crisis really took off when the ECB announced the end of its emergency liquidity measures in early December. Failure to tackle the crisis early and decisively has brought to the fore the risk of a sovereign default and the risk that one or more countries will leave the euro area. This is a lesson markets will not forget,' he said."

If I take seriously the statements made by Ms. Merkel, I have to conclude that she too is pretty much clueless about the fiat money system in which she is immersed as a major player. She blames the banks. The banks, as we have outlined above, are economic downstream players in this system. If she were alluding to the fact that the banks contribute to political campaigns, write legislation, and benefit from the central banking system, that would be one thing. They do help close the loop politically. But she seems to be complaining that they made too many loans:

"German Chancellor Angela Merkel accused the financial industry of playing dirty. 'First the banks failed, forcing states to carry out rescue operations. They plunged the global economy over the precipice and we had to launch recovery packages, which increased our debts, and now they are speculating against these debts. That is very treacherous,' she said. 'Governments must regain supremacy. It is a fight against the markets and I am determined to win this fight'".

If she believes that, all she has to do is make the central bank follow a monetary rule. It seems Germany could have done that on its own with the old German mark. It wanted to enter the EU and get some benefits from the euro. It seems bad form now to complain about the result of one's own actions and blame the banks.

The fiat system is hooked on e-credits and needs more of them. Otherwise it will go into shock. Merkel doesn't understand this, we are told. So this quote underscores:

"Marco Annunziata from Unicredit said EU leaders were losing the plot. 'The threat that contagion might eventually morph into panic and spiral out of control is very real, and the reaction of policymakers remains dangerously counterproductive. Demonising markets, implicitly casting investors as heartless speculators against the tragic background of the Greek riots, is irresponsible,' he said.

"Mr Annunziata said rising debt yields were an entirely rational response to the state of public finances. Indeed, the anomaly is that spreads for Greece and others ever fell as far as they did. 'Policymakers should act quickly to address the fundamental imbalances, as these cannot be regulated away. They should act immediately,' he said."

Trichet is the man in the middle.

"Giulio Tremonti, Italy's finance minister, rebuked Germany for letting the crisis drag on, saying 'no country is immune from the risk just because they are travelling with a first-class ticket.'"

On the other hand:

"The ECB is not allowed to buy eurozone government bonds directly because that would blur the line between monetary and fiscal policy, favouring big debtors. But it can buy the bonds on the secondary markets, and may in any case break the rules in an emergency.

"The German press has reported that the ECB's two German members are adamantly resisting such a move, deeming the start of a slippery slope towards outright 'monetisation' of Club Med deficits."

Sarkozy has criticized the ECB.

Sarkozy, Merkel, and Trichet met on May 7 in Brussels. The result is an EU-IMF loan package to Greece (110 billion euros) and a bunch of money (70 billion euros), whose source appears to be government and not the ECB, to intervene in the currency market.

These will not end the problem of defaults. More e-credits are the lifeblood of an e-credit system overloaded with defaults, but they do not resolve the underlying issue of money and debt creation. They become part of a greater e-credit bubble. The ECB already bowed to political pressures since its inception. It will bow some more. It will play its part in the crackup of the fiat money system. The notion of decoupling the central bank from e-credit creation is a dream.

Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York. He is the author of the free e-book Essays on American Empire.

    © 2010 Copyright Michael S. Rozeff - All Rights Reserved
    Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


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