'This is what a monetary union on the verge
of collapse looks like.'
Under normal conditions, the
interest rates that you and I must pay on a home loan, a car loan, our
credit card, a business loan are pegged onto two crucial rates. One is
the rate that banks charge one another in order to borrow from each
other. The other is the Central Bank’s overnight rate. Alas, neither of
these interest rates matter during this Crisis. While such ‘official’
rates are tending to zero (as Central Banks try to squeeze the costs of
borrowing to nothing), the interest rates people and firms pay are much,
much higher and track indices of fear and subjective estimates of the
Eurozone’s disintegration.
Following the Crash of 2008, banks
stopped lending to each other, fearful that they will never get their
money back (as most banks became, in effect, insolvent). Thus, the
interest rate at which they lend to one another simply ceased being a
meaningful price (just like the prices of CDOs, following Lehman’s
collapse, lost their meaning as no one bought or sold those pieces of
paper). The truly scandalous aspect of the Libor scandal of recent weeks
is that banks continued to use (and ‘fix’) an estimate of the interest
rate at which they lent to each other (for the purposes of fixing all
other interest rates; e.g. mortgage and credit card rates) when they did
not lend to each other any more…
The demise of Libor and other measures
of inter-bank lending interest rates left us with the official interest
rate of Central Banks, like the European Central Bank. Recently, in an
acknowledgment of past errors and of the strength of the European
austerity-induced recession, the ECB lowered its key interest rate to
0.75% – the lowest level since the euro’s inception. At the same time,
the ECB did something else that is extraordinary by its own standards:
it reduced to zero the interest rate it paid private banks for
depositing money with the ECB.
Under normal conditions, such an
aggressive interest rate reduction would drag downward all interest
rates: with private banks being able to borrow at a pitiful 0.75% from
the ECB to lend on to the private sector, and having no incentive
whatsoever to park their idle capital with the ECB, one might have hoped
(as the ECB’s President, Mr Mario Draghi, clearly did) that banks would
be more willing to lend and at a lower interest rate. However, such
hopes would have been baseless. Indeed, the interest rates p[aid by
households and companies remained high, the banks’ funding costs even
increased, and the normal ‘monetary transmission mechanism’ (i.e. the
system that converts lower official Central Bank interest rates into an
increase in the supply of money) proved to be broken and beyond repair.
The question is: Why?
Here is the answer, as provided by
Christian Noyer, a governor of the Central Bank of France
(in an
interview with Handelsblatt): “We are currently observing a failure of
the transmission mechanism of monetary policy. From the markets’
perspective, the interest rate facing individual private banks depends
on the funding costs of the state where they are domiciled and not on
the ECB overnight interest rate… Hence the monetary policy transmission
mechanism does not work.”
Now, this is an admission that should be
on every headline in Europe, given that it comes from a governor of the
Central Bank of the Eurozone’s second largest economy. It is equivalent
to a pilot picking up the intercom and saying to the passengers: “The
landing gear has failed.” And as if this were not enough, Mr Noyer added
for good measure: “We did our best to face up to this phenomenon which
is unacceptable for a Central Bank in a monetary union.” What did he
mean by that? The clue comes from his follow up sentence: “In future we
cannot rely endlessly on a system where the Central Bank is injecting
massive liquidity to the banking system, boosting hugely its balance
sheet.” Clearly, Mr Noyer was referring to the LTRO; the ECB’s attempt
earlier in the year to ‘fix’ the ‘transmission mechanism’ by pumping 1
trillion euros of liquidity into the Eurozone’s banks. Reading between
the lines, it is clear that, at least according to Noyer, this ploy
failed (as some of us kept saying it would).
In summary, borrowing costs in the
Eurozone have lost their two anchors: the inter-bank lending rate
(courtesy of the sad reality that the banks no longer lend one another)
and the overnight ECB interest rate (which banks ignore when lending).
The key to understanding this breakdown is governor Noyer’s phrase “the
interest rate facing individual private banks depends on the funding
costs of the state where they are domiciled and not on the ECB overnight
interest rate”. In short, the fear of a disintegration of the
Eurozone (that is aided and abetted by silly talk of Greece’s and
Portugal’s expulsion) has broken the umbilical cord that normally
connects the ECB’s overnight rate with actual borrowing costs of the
private sector. Now, the later reflect the fear that the member-state in
which the firm or the household are will not be able to refinance
itself. In a never-ending circle this fear ensures that the said
member-state will not be able to refinance itself and, crucially,
guarantees the ECB’s failure to lower interest rates even when it pushes
its official rates to zero. This is what a monetary union on the verge
of collapse looks like.
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