22 September 2012

How Much Does It Take to Manipulate Interest Rates?

“How much does it take to manipulate interest rates?” I recall a news correspondent asking provocatively back in summer. The question was not about the LIBOR scandal. The question was about the central banks’ monetary policy which has been remarkably unsuccessful, not to say disastrous when it comes to solving the crisis.

“I’m not Dr. Doom; I’m always Dr. Realist,” Nouriel Robuini said in an interview about the eurozone’s gloomy outlooks around the same time. “The eurozone is a ... it’s a huge mess. It’s a slow-motion train wreck. Fragmentation, balkanisation, disintegration... seven countries in crisis... Lack and loss of competitiveness, large external deficits to be financed, deepening recession in the periphery... That looks ugly,” he continued the remark about his nickname “Dr. Doom” with describing the situation in Europe.

So far, his gloomy prediction seems even too realistic for the many observers, especially for those looking from a distance. Despite of Greece and other “peripheral countries” reportedly making progress in introducing reforms (even though too slow), people (at least those who still have jobs) working harder, companies improving efficiency and so one, economic outlooks haven’t improved – rather other way round.

Something is definitely wrong with the European monetary policy and it is not that the ECB is not “printing” enough money (more money would not make it working). Today we can perceive some decisive (or desperate?) changes ahead which make a piece of chronicle writing and speculating about the future interesting.

In his recent 20 September 2012 speech (to be taken as promotion to the on 6 September 2012 announced OMTs), Benoît Cœuré, Member of the Executive Board of the ECB, underlined this point by explaining in a difficult-to-understand professional manner that as the true situation of the eurozone has been increasingly scrutinised and debated, the normal central bank’s monetary policy channel of “manipulating interest rates” has ceased to work. [Note the irony: normal monetary policy ceased functioning as soon as questions started to be asked about the health of the financial system.] This is simply because no sensible creditor grants credit to a de facto defaulted counterpart such as a large European bank that has lots of questionable assets on its balance sheet. “Having tasted the forbidden fruit of excess risk-taking, financial institutions were cast out of the paradise of seamless financial markets,” he adds more illustratively.

So the ECB tried out opening the “liquidity channel” by lending banks directly at a fixed interest rate, the main refinancing rate as it is called. The hope was that this would keep credit flowing and, via continuing providing re-financing, hide underlying debt problems for long enough time. Another hope was to quietly improve the situation for the large European banks that would be able to use cheap money for purchasing highly rated securities (EFSF bonds, for example) and retain earnings for building up stronger capital bases and gradually writing off bad loans.

The strategy has helped to “kick the can” down the road so far but not much more. For one thing, gradually it has become clear that German tax payers (and not only they) had actually not subscribed the by the Europe’s financiers’ assumed implicit guarantee to bail out weaker eurozone countries should it become necessary. While the policy makers debated, observers started to speculate about the eurozone break-up. The distinction between the “core” and “periphery” made money to escape from the later, and the embrace between the banks and sovereigns lethal. In result, no matter the ECB’s efforts, its monetary policy measures do not reach all countries in the same way or do not reach at all. This of course may easily lead to the Roubini’s expectations to be self-fulfilling... As an example, national supervisors have reportedly given their banks instructions to bring money back home.

Currently the ECB presents its Outright Monetary Transactions (OMTs) as a solution for making the monetary policy measures working once again. New is that it has publicly acknowledged the above described challenges, plus stressed that its fire power in terms of the ability to “print” money is limited. Now together with the European Commission and the IMF, it is pushing towards quick (and thirty) European integration, incl. banking union and fiscal union that will lead to political union.

I’m adding “thirty”, because the delegation of sovereignty of individual countries that has not been achieved in democratic debates so far is now intended to be achieved by putting disagreeing politicians under the time pressure of someone called Mr. Market. Those who do not agree may be left out. I’m also saying “thirty” because the underlying debt problem still remains largely unaddressed – but who cares until it can be neglected.

To answer the question that we asked at the beginning: manipulating interest rates may not take much but if having had done only this, central bankers would have been kicked out of the office some time ago.

Finally: a small guess work. Will this “quick and thirty” integration project succeed? I think so (with some drop-outs possible) because there are a few more “thirty little secrets” which make even disagreeing politicians vote “For”. Not least important are the too-big-to-save vs. too-big-to-fail issue when it comes to the banking sector and formation of the banking union, and the more general desire of Europeans to retain power in the multi-polarising world. If the efforts of the last 50+ years would be undone now, it would be a huge waste of time and efforts committed already.

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