Wednesday, 24 November 2010

Free for all in the eurozone?

In Autumn 2008, I attended a small public meeting entitled 'Sound Money'. I learned that for years the commercial banks had been getting away with literally printing money by issuing loans on the back of money they simply did not have.

On leaving the meeting, I was fired with the righteous indignation of the newly awakened and immediately wrote about the power and irresponsibility of such banks on an online forum. Instantly, I was seriously flamed by a professional banker, who insisted that talk of banks creating money out of thin air was total rubbish and I should get a grip on fractional reserve banking rather than spread such blatant ignorance.

Duly chastised, I studied fractional reserve banking. Banks did indeed maintain a relationship between the deposits they received and the money they lent out. But this relationship – the multiple of the amount held against the amount lent – had been stretching for years. And, given the additional practice of banks like Northern Rock of borrowing further sums in the international markets to lend to borrowers, it was little wonder a run on the bank soon resulted in that bank's collapse and others quickly realising they could no longer continue lending on such thin reserves.

Commercial banks, of course, are responsible for their own solvency – at least, up to the point where governments deem that allowing them to fail would undermine public trust in the financial system as a whole. It's at this point we get government bailouts: RBS and Lloyds in the UK and, rashly, a financial guarantee for the whole of the nation's commercial banking system by the government of the Republic of Ireland.

I am a little weary of reprising my eurosceptic credentials, but suffice to say, if Ireland was a truly sovereign country – that is, if it managed its own currency, the Irish Punt – it might have had some hope of staving off the swirling pirhanas of the bond markets for a little further time.The practice it would almost certainly have adopted is the same as that used by such illustrious independent nations as the UK and the USA. I speak of Quantitative Easing (QE), of course.

The advantages of managing your own Central Bank sadly have been much underestimated across the capitals of Europe. Not only do yet get to manipulate your own interest rates and exchange rates, you also get the opportunity to engage in QE. It is a trick that commercial banks – especially those that have stretched lending beyond their means unto insolvency – must desperately envy. For QE is that ultimate goal of both alchemist and banker: the ability to actually create money out of thin air.

QE has received a mixed press from economists. Some instantly recognise that it must be a recipe for stoking inflation. Others are more sanguine and judge it may be a harmless tool to stimulate an economy at a time of deflation. No-one, however, seems to have pointed the finger at the damage QE may yet inflict on the Eurozone currency.

For many months, the European Central Bank (ECB) has been supporting government deficits in Greece, Ireland, Portugal, Hungary and perhaps even Spain. Greece and Ireland have been receiving rolling handouts to keep their debt payments afloat. Now, a 'once-and-for-all' financial package has been arranged for Ireland, with the ECB at the core of the deal.

The ECB may not admit to following other central banks, but it too provides funds by engaging in QE: printing money. And the EU in Brussels is determined that such financial support must appear unequivocal if the integrity of the eurozone and even the EU is to survive.

But what has been the reaction of the bond markets to this latest Irish financial support? The answer is very little – in fact, they seem to be saying "is that all?". And can you blame them?

QE represents a bottomless pit of an ever-expanding money supply. If demanding 5% yield for investing in Irish government bonds brings this kind of guarantee, why not demand 6%...7%...8%? Such printed money is effectively free. Roll on the bond market calls in Portugal, Spain and Italy!

If my doubts about QE seem as naive as my understanding of fractional reserve banking, just ask yourself where, when and how will it end? The European financial institutions are becoming slaves to the markets. Each new bailout devalues the euro's credibility. The bond markets may not be satiated until they've escalated and extracted every cent the ECB is willing to issue to defend eurozone solidarity. If the euro survives it may be minus several members.

Even more importantly, if the global financial system is to survive with future credibility it might be time to consider what is really meant by "sound money". It surely can't mean just printing ever more money for the benefit of bond traders.

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