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.

The long term NOT quantitatively easy

Not much blogging yet on the implications of Quantitative Easing. Well, it does take some head getting around.

The Yanks have been doing it for some while as Reuters has explained in some detail. The DT lays out the UK version a little more simply here.

As you will no doubt now understand very well, the purpose of the UK's quantitative easing is not so much to inject £75 billion or £150 billion potential spending into the economy as to achieve, by so doing, the lowering of long-term interest rates.

This is because, unlike short-term interest rates, the BofE normally has no influence over long-term rates at all.

Why doesn't the Treasury simply buy back gilts in market operations as it would normally do? Yes, you got it, the Treasury is somewhat overdrawn on £trillions of our loose change already.

The government's loss of control over the economy - through monetary and fiscal policy - is alarming. It is taking the bribe of up to £150 billion more (this time of phantom money) to try to influence confidence in future market conditions. And there is no certainty it will.

Banks and others could still just pocket these funds. And as I have said below, stimulating market activity into self-sustaining growth requires more than giving banks and businesses money. It requires a return to confidence by our consumers in their long-term economic future.

The public's love affair with borrowing is gone and their inclination to unnecessarily spend is over. The long-term debts the government has placed on all our heads may have a more significant impact on our economy than even quantitatively eased long-term interest rates.

Q&E – but where are the slumdog millionaires?

I am not a professional economist. And my early banking career was very short-lived. Does this explain my lack of confidence in today's Bank of England's decision to cut interest rates by another half percent and ALSO announce a programme of quantitative easing (QE)?

What is the Bank / government trying to achieve? Obviously, it is trying to re-stimulate lending by our banks in the hope that this will kick-start economic activity.

But pardon me for making this observation. While there may be many businesses being harshly treated by their banks (by restricting reasonable access to cash flow), there are many more with turnover that has dramatically declined who can't reasonably expect banks to provide credit on previous business terms, if at all. It's not reasonable for banks to substitute lost turnover with loans when there's no expectation of an end to the current depression.

Businesses do not exist in a world of their own, able to expand and flourish as long as they can borrow money. Businesses need customers, who are both able and willing to spend. For the foreseeable future, the public will not be entertaining any spending sprees. They face unemployment, crashing housing assets and their government (without formal request) has purloined several trillion pounds of their future earnings, which at some future date must surely be paid up.

Mervyn King probably does get this. Last month, heralding future QE, he said, "the balance of risks to the path for GDP is very much to the downside, reflecting in large part uncertainty about when lending and confidence will recover".

In other words, even if introducing quantitative easing does reduce long-term borrowing rates, restoring economic confidence may be a separate issue altogether.