Tuesday, May 7, 2013

Austerity and ECB Policy

Last Thursday the ECB announced a 25 basis points reduction in its overnight rate bringing interest rates to 0.50%, the lowest level they have reached in the Euro era. An accommodative policy has been adopted by the Federal Reserve, ECB, Bank of England since the Financial crisis in 2007-2008, but all the evidence suggests this policy has failed miserably to stimulate many of the major economies in the developed world, with contraction again the dominant force in Europe and Japan, while the US experiences a moderate recovery. The Euro area economy contracted at an annualised rate of 0.6% in the final quarter of 2012, while Japan contracted at a rate of 0.4%. The UK economy grew by a slight 0.6% annualised rate in the first quarter of 2013, while the US economy expanded by a more impressive 2.5% in the same quarter.

Little to none of the cheap money being fed into the bank chain from the top of the hierarchy by the Central Banks is making its way into the real economy - i.e. by way of retail bank support and lending to small businesses and end consumers. If the people that are the lifeblood of the economy are starved of cash and disposable income, then the real economy is missing the basic stimulus it needs to grow and the Central Banks need to reassess its policy, or, more importantly, reassess how the institutional banks are interpreting their policy. Owing to flagrant indifference of the banking sector to the Central Bank's policy intentions, any trickle of funding that does currently make its way from the banks to the real economy usually brings with it a vastly inflated interest rate tag, just to reinforce the fact that accommodative monetary policy is not accommodative where it is needed. None of this money is available at an affordable price where it is needed most.

But if the cheap money being ushered out by the Central Banks is not going into the real economy, where is it going?

Answer: Into risk assets such as commodities, bonds, even equities. How? The institutional banks are borrowing cheap money from the Central Banks, such as the Fed, ECB and Bank of Japan, and rather than making this money available for end borrowers (the original intention of the Central Banks), the Institutional banks are diverting the cheap funds from the Central Banks into their own investment channels, to speculate on higher risk investments in the hope of a more profitable and quick return. For the most part this tactic has worked over the last 3 years with largely exaggerated price increases achieved in commodities and equities, while sovereign bonds in many defunct European countries are now achieving close to record yields for investors. The added political lobbying by bank interests of influential governments within the European Union has helped to safeguard bond investments, as the EU currently prohibits sovereign debt write-downs and the burning of major bondholders exposed to Europe's burgeoning sovereign and banking debt. Any country that might consider straying from this policy is threatened with expulsion from the Euro.

For the institutional banks it is a no-brainer. Why lend money to the man on the street or to someone starting up in business, with the risk that entails, when the option exists to direct this money into a 6% yielding bond, a speculative fund investing in oil futures (up 50% since 2009), or gold (still up 113% in the past 4.5 years despite a recent sell-off) or equities (The Dow is up a massive 130% in the same period). A 5-year term loan given to a small business might yield 18% over 5 years and is not without risk, while a mortgage given to an end consumer might yield 40% after 20 years. The differential gap in terms of potential yield between investment risk and lending risk is something of a moral dilemma for institutional banks, but not one they lose any sleep about, and when push comes to shove it is lending to the real economy that is losing out to speculative investment. Of course what this means is that with cheap and free money barging its way into riskier assets, these assets have grown at a rate which is completely out of synch with growth in the underlying economies and thus the aforementioned assets are completely overpriced in real economic price terms and the run-up in prices is unsustainable, and many of these assets are soon headed for a serious downward correction, if not crash landing, in the not too distant future. Oddly enough, given the impact of political bullying and potential ECB intervention, sovereign bonds within the Euro area may be at the lower end of this risk investment scale.

So what does this mean? Central Banks are accelerating a policy of providing cheap money to banks so these banks may use this money to invest in risk instruments rather than lend this money to the real economy. The net result for many of the underlying economies is economic contraction as government austerity measures intensify and fuel costs continue to inflate, thanks largely to the speculative investment which the Central Banks are inadvertently helping to fuel. Cash-starved businesses in developed economies are being run aground and unemployment in Europe is now at a Euro era high at 12.1%. Japan's Central Bank is currently undertaking desperate measures to try to discredit it own currency with the result that the currency has fallen 28% against the dollar in the past 8 months, while the Nikkei has soared 63% since the middle of November. The price moves in Japan are totally at odds with the economy's lack of economic growth and its underlying fundamentals and the price moves appear more fictional than real. It just does not seem plausible that such moves can occur and be representative of the economic facts. But of course they are not representative of the real economy, rather they are representative of the repatriation of cheap funds originating from the speculative children (banks) of accommodative Central Bank policy, as their fund managers race trigger-happy across the globe, in an avaricious chase for big profits from risky assets.

Why are institutional banks allowed to borrow money for half nothing from the ECB, Bank of England, Bank of Japan and the Fed, when this cheap money is not finding its way into the real economy and is not being used to help the economies of the Euro, UK, Japan and United States? The reason is simply because, despite the near-collapse of the banking sector in Europe just a frighteningly short time ago, the ECB and other major Central Banks have failed miserably to impose the proper regulatory procedures required to keep the money distribution policies of banks under control. It is incredulous that the ECB itself has not imposed stricter rules and monitoring procedures, for tracking cheap funds being poured into the banking sector, given the strict rules it has imposed on the Governments of the Euro area, forcing an era of severe and heretofore unseen levels of austerity, for most of the citizens of the Euro area. Is it that the ECB, and Central Banks generally, are run by bankers whose modus operandi is for the benefit and growth of banks, moreover the real economy and its citizens?

Bob - 7th May 2013