The European Open Mouth Committee – Real and Psychological Factors

by Pater Tenebrarum

ECB: What is its Talk Actually Worth? Many people are beginning to wonder these days how long the ECB's trick of promising action instead of delivering action will continue to 'work' (allow us to interpose here, that we believe the less they do, the better it is). To understand the activities of the ECB in recent times, one must keep in mind that central bankers far and wide have become convinced that their ' forward guidance' is an extremely powerful tool in the central banking 'tool-box'. We would argue that this is only a half-truth. It is true that psychological factors are an important driver of financial market activity, but if one analyzes historical contingencies on a case by case basis, one soon realizes that  whatever psychological effects one was able to observe were always supported by real forces. In order to bring this into context with the ECB, it has often been argued that Mario Draghi, by merely holding out the promise of 'OMT', managed to steer the euro area's sovereign bond markets from panic to relative calm. Lately the 'calm' has actually evolved into a state of utter complacency: Spain's 2 year government note yield: from total panic to serene complacency. Meanwhile, Spain's public debtberg has continued to grow by leaps and bounds – click to enlarge. The Real Factors We never believed that this was a realistic assessment, and felt that the promise would eventually be 'tested' by the markets. This certainly hasn't happened yet (quite on the contrary, markets act as if there were no longer any problems at all), but we are indeed able to enumerate the 'real' factors that have been the root cause of the improvement. In no particular order, these were: 1. A decline in trade and current account imbalances within the euro area, and the associated decline in the TARGET 2 payment system's imbalances. This was achieved by means of grueling recessions in the periphery and the re-nationalization of government debt financing (more on this below). The decline of TARGET-2 imbalances in the euro-system - click to enlarge. 2. A vast surge in government debt purchases by banks on a national basis (said 're-nationalization'), with Italian banks and Spanish banks buying truly stunning amounts of the debt issued by their own governments. We cannot prove it, but we do believe that there exist sub rosa agreements that have made this possible. We can e.g. describe the process in some detail with respect to Italy: when the ECB announced it would offer 3 year LTRO funding (which would be extended 'if necessary') to euro area banks, the Italian government extended 'guarantees' to numerous debt securities held by Italian banks, in order to make them eligible for discounting with the ECB. It was a bit as if Worldcom were offering to prop up Enron. Here is how one of the tricks employed worked in detail: a) banks buy properties (old army barracks, office buildings, etc.) belonging to Italy's government, paying for them with Italian government bonds. b) the government leases the properties back from the banks. c) the banks turn these properties into ABS (asset backed securities). d) Italy's government  'guarantees' the ABS. e) the banks pawn the ABS at the ECB for ultra-cheap LTRO funding and use the funds received to buy more Italian government bonds. f) lather, rinse, repeat, ad infinitum. Note that the ECB is now effectively the owner of Italian army barracks, among other things. Bank holdings of government debt by country, changes over several time period. Note the huge surge between Nov. 2011 and Mar. 2012 at Italian and Spanish banks (in blue) – click to enlarge. 3. A sudden strong increase in euro area money supply growth (which had collapsed close to zero year-on-year at the crisis peak), occasioned by the activities described under point 2, namely the massive extension of bank credit to governments in the wake of the LTRO. Note that it is completely erroneous to assert, as some observers have done, that the accumulation of excess bank reserves on the ECB's balance sheet means that banks 'are not using the money'. People saying this simply don't understand double-entry bookkeeping, or how money is actually created in the modern-day fractionally reserved pyramid scheme. We have discussed these points in great detail previously, but let us just reiterate here: the accumulation of excess bank reserves is definitely not an obstacle to the growth of circulation credit in the real economy. The opposite is actually true. Euro area true money supply growth rate, year-on-year. Note the post LTRO surge – click to enlarge. 4. Other measures taken by the ECB that served to reliquefy the technically insolvent banks in the periphery, such as lowering the reserve requirement to a mere 1% (making 100:1 leverage possible with respect to the demand deposits of customers!), and a continual lowering of the eligibility standards for assets pledged with the ECB for refunding purposes (the ECB has ended up looking like a hopelessly over-leveraged hedge fund stuffed with toxic crap as a result). 5. And lastly, the fact that after several years of truly severe economic downturns, the economies in the periphery had been purged of a great deal of malinvested capital. At some point even the most painful recessions end of their own accord, namely at the point when capital has become cheap enough to compensate for the remaining risks and thus entice investors to step in, and the portions of the capital structure that have become entirely useless have been largely written off. Thus a recovery in euro area economic activity became a realistic prospect, almost regardless of the words and deeds of the central bank. 6. Lastly, several countries have enacted economic reforms, which although they don't nearly go far enough, have contributed to restoring a modicum of confidence. Conclusion: Our contention therefore is: the only reason why verbal intervention seemed to suddenly 'work' is that the underlying real factors supported it. Readers may recall that prior to 2012, the crisis continued to worsen, no matter what EU politicians or ECB board members said. It follows from this that 'verbal intervention' will cease to work once the underlying real factors are no longer supportive. With euro area money supply growth rates slowing down sharply recently, this point is presumably coming ever closer. Although a lot of malinvested capital has been liquidated or re-purposed as noted above, we can be fairly certain that the central bank's manipulation of interest rates and the money supply has arrested the liquidation process and created new malinvestments taking the place of old ones. Moreover, many of Europe's underlying structural economic problems remain unresolved, and the indebtedness of governments has continued to grow. Banks and sovereigns meanwhile are even more entangled than they were before.

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