A lot has been made of the recent, more positive statistics on Eurozone growth, unemployment and inflation, which might lead Cash Managers to anticipate a rise in Euro interest rates and a possible reduction in the Quantitative Easing programme of the European Central Bank.
Such a diagnosis would seem akin to celebrating that a victim of major trauma on life support has not yet been pronounced extinct.
Eurozone growth is almost entirely attributable to the money-spending of the European Investment Bank:
- Under its so-called 'normal' loan programmes, where they finance commercial banks and almost any project that has public sector support
- Under the European Fund for Strategic Investments ("EFSI") where the EIB funds – under a first-loss guarantee from the EU - almost any project where a public body contracts to buy the offtake
EIB borrows at 10-15 years, and lends money that is spent straight away: currently the spending is 0.65% per annum of EU GDP. In exchange the EIB and/or the projects load up on medium-term debt that the EU’s taxpayers have to repay:
- By acting as end-user of the offtake of EFSI projects
- By paying, through taxation, for the public projects created under EIB's 'normal' loans
- By injecting new capital into the EIB through their Member State government
All that is really happening is a transference of the contractor of debt, away from Member State governments because their direct borrowings are controlled by the 2012 EU Fiscal Stability Treaty, and onto project companies, regions, municipalities, other public bodies, all of whom draw their debt service from the same well as the Member State governments.
Aside from this limitless ability to create new borrower entities attempting to draw debt service from the same parched public-sector well, we have the corruption of the definition of 'central bank money' being practised by the ECB in order to keep the commercial banks afloat in their financing of the private sector.
In our developed monetary systems we have all types of scriptural money carrying different characteristics of safety, liquidity and yield, all supposedly resting on the existence of "central bank money", an asset free of credit risk, of which there are three types:
- Note and coin
- A credit balance on an account at the central bank
- Government securities of that country and in its own currency
The prime example of the third type in euro is the government bonds of the Eurozone member states, the yields on which should have converged after the application of the 1997 Stability and Growth Pact and some years of euro membership.
The three types of "central bank money" must be fully fungible with one another: instantly interchangeable and with no haircut. Furthermore, a central bank should only make loans of "central bank money" against security of "central bank money".
So a central bank can allow a commercial bank – or the central bank of another country – to overdraw its account in the central bank's books as long as it pledges either (i) note and coin held in the central bank's vaults; or (ii) government securities of that country and in its own currency, the government being the UK government if the lender is the Bank of England.
The Bundesbank should not be able to overdraw its account in GBP at the Bank of England by pledging either:
- German government bonds in GBP; or
- German government bonds in EUR.
But from 1/1/1999 the euro's coherence was compromised by the ECB's own definition of what constituted "central bank money". Its lists of collateral eligible to be pledged as security for loans taken at the members of the "Eurosystem" (i.e. at one of the Eurozone national central banks) contained items that were some way distant from a normal interpretation of highly-liquid government bonds. In all cases the collateral could be valued at full face value without a haircut.
On 1/1/2002 Euro note and coin were introduced, and the euro ceased to exist as scriptural money only. Euro notes are the obligation of the European Central Bank ("ECB"). Euro coin are issued by the national central banks of Eurozone countries, one side having a national design and the other a common one.
The Holy Roman Empire
Here we have a curious echo of the Holy Roman Empire. The Holy Roman Empire had 200+ "member states" and each issued its own thaler coins – completely different on one side but with the head of the "member state" ruler on the other.
These thaler coins all had the same value because they weighed the same in gold. The thaler coin of the Holy Roman Empire was a unitary currency. The Holy Roman Empire had no bank notes, no scriptural money and a very limited pool of debt instruments, and it also lacked any kind of driving bureaucracy at the centre introducing measures to:
- Create a single and harmonised economic area across the Empire;
- Reduce the power of the rulers of its member states:
- 100+ princes
- 50+ free cities
- 50+ bishops and archbishops
Now we do have that driving bureaucracy, and an aspect of it is the ECB and its single list of bonds that can be pledged as collateral, and the haircuts applicable to each bond. The existence of a haircut at all and in relation even to the bonds of Germany is an admission that none of these bonds represent genuine "central bank money".
The ECB's list of eligible collateral runs to nearly 30,000 bond issues, with haircuts from 1% to 30%, recognising that the credit ratings of many banks and Eurozone countries merit haircuts larger than those of corporates. The issuers of these bonds are governments, municipalities, cities, banks, corporates and securitisation vehicles. There appear to be no princes, bishoprics or archbishoprics, but otherwise there are strong overtones of the constituent elements of the Holy Roman Empire.
Bearing in mind the mantra that central banks should only grant credit (which is by definition a credit of central bank money because its granting creates a credit balance on an account at the central bank) against collateral that is one of the other forms of central bank money), the ECB should not be making any loans at all that are collateralised with assets that are anything but central bank money. Furthermore, if the collateral is in a form of central bank money, no haircut is needed to as all forms of central bank money are instantly interchangeable with one another at face value.
And yet the European Monetary System now allows parties to borrow central bank money against assets that are not central bank money, and to enable this it assigns haircuts whereby the borrower can only take a percentage of the value of the collateral: face value less the assigned haircut.
The list demonstrates that the Euro is not a unitary currency – it exists in 30,000 forms. As a result the Eurozone economy is not resting on the bedrock of "central bank money" that a modern economy should rest upon.
What does this mean?
The upshot is that the euro has never had "central bank money" underpinning it in the same way as the GBP, JPY, CHF and other sovereign currencies do. The European Monetary System has all along been based on comparative credit risk, not absolute credit risk – which actually means the absolute absence of credit risk in genuine "central bank money".
The ECB and the Eurosystem as a whole have become a focal point for a gargantuan concentration of credit and liquidity risk, whereas a central bank should operate without taking any credit risk. As for liquidity risk, the idea that the ECB could liquidate collateral like bonds of Stad Ronse or Stad Hasselt in Belgium - if pledged by a Belgian bank – in the circumstances that the Belgian bank in question had gone down is laughable: the circumstances that have led to the Belgian bank going down would be ones leading to the illiquidity of the collateral. The ECB and the Eurosystem have become a focal point for correlation: making loans against collateral that is not independent of the borrower.
But in a sense the ECB and the Eurosystem have no alternative because Europe’s commercial banks are illiquid:
- They have large long-term loan books
- Their retail deposit base is not growing
- Their credit ratings are too poor to enable them to fund themselves from the interbank market
- They are not so profitable as to create new funds internally or to attract them from outside investors
There is indeed no alternative but to continue with the ECB acting as bank of first, last and middle resort to the private banks, and with EIB acting as bank of first, last and middle resort to the public sector, but one should not delude oneself into believing that the headline statistics created by this level of EU intervention are deriving from any fundamental recovery in the Eurozone economy.
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