Markets No Longer Create Real Value

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On May 10, 2010, the European Central Bank (ECB) created the Securities Market Programme (SMP) in response to the relatively new rejection of largely Greek sovereign debt securities. Alarmed by illiquidity and the implications for the wider economy, the ECB announced its intentions:

"To conduct interventions in the euro area public and private debt securities markets (Securities Markets Programme) to ensure depth and liquidity in those market segments which are dysfunctional. The objective of this programme is to address the malfunctioning of securities markets and restore an appropriate monetary policy transmission mechanism."

The key sentiments in that statement were certainly the connotations of "malfunctioning securities markets" and the "appropriate" ability of the ECB to respond to such unsuitable pricing via monetary means. Given the blanket promise that such a program might offer in terms of scope for a growing level of "dysfunction", the ECB also pledged to offset these bond purchases:

"In order to sterilise the impact of the above interventions, specific operations will be conducted to re-absorb the liquidity injected through the Securities Markets Programme."

The original target, as mentioned above, was that tiny economy nestled on the Aegean, the Greek Republic. The first iteration of the SMP was designed to settle bond markets by providing enough liquidity so that the Greek government would be able to maintain funding. The augment of ECB buying would, in theory, reassure markets that the Greek government would not be undone or unduly stressed by punitive market interest rates. The recoil of private investors to the default potential given both the fiscal and real economic state of Greece in 2010 was essentially deemed inappropriate by the ECB.

As a matter of due course, the political powers in Europe did acknowledge the market's initial concerns, addressing them by imposing "austerity" conditions on the Greek government. The twin intervention of fiscal aid and monetary interest rate mediation was guaranteed on several occasions to keep the Greek sovereign market solvent and the Greek economy under the common currency regime.

Of course, two years later the first SMP failed to keep the Greek sovereign market from default. The markets were not malfunctioning at all; in fact they were, if anything, not harsh enough. Earlier in 2012, the Greek government imposed a debt restructuring on the private sector that did not include any of the bonds purchased by the ECB through SMP1.

By the summer of 2011, however, the whole of the European banking system was fully engulfed in a wider recognition that Greece was not in isolation. The fires of private sector abhorrence had spread to Italy and Spain (after consuming Portugal and Ireland), so the next panacea to preserve private source funding was the unprecedented maturity extension of ECB monetary reserve access through the LTRO's. Since European banks make up the bulk of the "private" sector class of investors in the various Eurozone sovereign debt markets, providing direct "liquidity" to those banks, in theory, should have been enough of a bridge to maintain the fiscal operations of each afflicted nation. If public intervention through SMP1 was not enough of a boost, private liquidity through the LTRO's was the logical next step.

Now, after a summer of yield decompression in the periphery coupled to negative interest rates in the core or in sovereigns denominated in other currencies, we are back at SMP's again. Despite hints and suggestions that the new SMP would be unlimited and untethered, SMP2 apparently will feature the same process of sterilization and subject to conditionality - the Germans needed something.

These attempts at sterilization ostensibly are acknowledgements that central bank balance sheet expansion is potentially inflationary, particularly in how inflation formulates and foments through the expectations of economic agents. While that certainly is a debatable point, for our purposes here I want to address the technical nature and the implications of what the ECB is trying to accomplish through sterilizations and the round trip of bond purchases.

The deterioration in peripheral sovereign funding markets was accompanied by a growing capital retrenchment, at first, followed by an internal drain of funds outside of national boundaries (even though they largely remained inside the currency zone). As banks domiciled in "core" countries grew pessimistic on the ability of peripheral nations to maintain their debt securities without restructuring, in the process actually trying to live up to their intermediation role, they first abstained from debt auctions, unsettling the smooth transmission of interest rates uniformly into the larger economy. SMP1 was the answer to bring back banks to auction (oversimplification here).

Broadly speaking, as the SMP1 effects faded and sovereign rejections drew in more targets (these bond vigilantes that were, in 2010 and early 2011, decried as evil speculators) and political promises proved laughably hollow (Portugal would never need a bailout, Greece will never default, Ireland doesn't need IMF help, etc.) sitting out actions turned into active selling. The ECB did not anticipate an inflection in "private" sector attitudes toward the risks of sovereign debt. After all, under the regulatory regime of the Basel banking rules, all OECD sovereign debt, including all the PIIGS, was and is considered "risk-free".

Banks actively selling out the peripheral government bond markets did not keep their euros in those markets, however, they "repatriated" them to their home National Central Banks (NCB). Despite the appearance of a common currency and marketplace, operationally the euro-system still adheres to national boundaries in some important respects. As the tide of "foreign" capital receded from the afflicted nations, central bank imbalances began to grow - the capital account deficits "financed" by the now infamous TARGET system. The funding divide has become immense as the private sector withdrawal of financing has now moved beyond bank retreat into retail deposit flight (particularly Spain).

For the ECB, then, the problem is not just fiscal budgetary affairs of afflicted nations and the credit perceptions attached to them, but the balance of payments between geographic regions. As a central bank committed to "price stability" system-wide, the ECB has essentially a bifurcated system working in opposite directions. The core receives the monetary largesse of central bank "stimulus", while the periphery gets none of it. This is the European version of the broken monetary transmission mechanism (the US version is different in that it does not seem to feature a geographic dimension).

The task now, in strict operational terms, is to get the euros out of the core and back into the periphery in order to try to achieve some kind of uniformity, or even minimal operation effectiveness. Back in late June, it cut the interest rate it was paying on its deposit account program - which had seen almost €800bln euros lay idle - to 0%. While there may have been some movement in money outside the ECB as intended, it appears that only core bond markets saw incremental buying (yields fell further on German and Swiss short-dated debt, for example, while Spanish and Italian yields continued to rise).

So in some ways the new SMP is an exact reversal of that deposit rate cut. In order to sterilize SMP2, like SMP1, the ECB will offer Fixed Term Deposits (I have not yet seen any details). I believe the plan here is relatively straightforward: the ECB is going to take in euros from core banks through the sterilizations of the fixed deposits and then flow them into the peripheral debt markets by buying afflicted government bonds (though this will be described officially in the opposite order). Essentially, between SMP1 and SMP2 the ECB has become the mechanism of intermediation between whole geographic regions.

The overarching question about this, aside from the nod toward outright monetization, is the implications of a central bank becoming a direct intermediary. By carrying out any SMP program, the ECB is performing a market function of credit risk transformation of private money, and allocating that credit according to political, rather than financial, calculations.

There has been, since 2007, a struggle between central bankers and the "markets", extending into the realm of prices and "correct" prices. It has been conventional mainstream theory that markets are efficient only until a crisis hits. At that point, because of tangential considerations such as liquidity and unsophisticated emotion, markets cease to provide "good" information about the state of banking and credit. In other words, fears and firesales of widely held assets project losses that do not reflect true values, and thus the true solvency state, of financial participants. As I mentioned last week, this leads to "good" banks failing with "bad" banks. Markets are, if this formulation is true, incapable of allocating monetary resources during crisis periods.

However, that reasoning only goes so far. Markets should not be permanently disbarred from rendering allocation verdicts. At most, central banks, according to their own theories, should be operating in very limited timeframes. Debilitating emotion is not permanent. Even if you accept the premise that markets need this centralized override every now and again because of temporary inefficiency, once the emotion of the moment passes natural order must be restored. If markets can be suspended for other-than-temporary-impairments (to use an all-too-appropriate accounting phrase), the very nature and character of the market system is unambiguously altered.

If a central bank is to intrude itself into the private sector's province of resource allocation or even monetary allocation among the contours of the banking system, the private sector, for all intents and purposes, has ceased any distinction. At that point, where temporary market intervention turns into a general suspension of market-based judgment of credit and risk conditions, is it not the economic equivalent of martial law?

Taking over the allocation role, even if done under true benevolence and the spirit of human empathy (which is certainly not how I would describe the monetary politics of Europe), changes the character and, far more importantly, the information content of the economic system at its primary step. Importantly, because this is the crucial step in the economic/monetary nexus, the intentional deviation is incorporated into growing error components in that system - like an error that compounds in an unbalanced equation through successive iterations.

While the ECB will defend this alteration as a necessary step to achieve its price stability mandate, it is hard not to perceive the irony in suspending market price discovery to enforce targeted prices. What are we trying to sustain, the number itself or the means to achieve the number? Central banks previously tried to do both, but we see here the misguided attempt at forcing stability into a chaotic system that decries the mistaken notion that price stability actually exists. The chaotic market system is not one intended for price stability, but rather true stability is achieved through the constant and chaotic churn of human life and the ability of the billions of dispersed opinions of a marketplace to uncover "value". The economy needs stability in the means to achieve its number, not in an actual number itself.

In his 1958 essay "I, Pencil", Leonard Read described the utter chaos and marvel that went into producing something as mundane as a pencil. In the course of discovery, Mr. Read uncovered a previously unappreciated complexity and majesty that can only come together when the various components are allowed to emerge on their own from all the chaos of human economy. Not only is central dictation absent, it has no logical place in the process. Pencils don't arise from the target; they arise from the stable process of free association and allocation.

The first SMP was in place in May 2010, and at that time the real economy in Europe was still growing. Two years later, the economy is now in re-recession (including a noticeable decline in even Germany) that is deepening in the very segments that were the intended beneficiaries of monetary martial law. The ECB will say that is because the transmission mechanism is broken in those regions, but the consistency of the market judgment has loudly proclaimed that it wishes to stop throwing good money after bad. Even gamblers know that there is a time to cut losses and head for the "free" buffet. The ECB is Gamblers Anonymous in forceful reverse.

The ECB has not only overstepped the traditional bounds of even the standards of modern central banks, it has proved that intended targets or prices are more important than preserving market processes. The primacy of central analysis and artificial appeals to "macro" variable targets are the elements of instability in that they upset the natural order of allocation processes. In doing so there can be no more appeals to temporary inefficiency and emotion, irrationality and fear. The ECB has shown in practice that it has reversed the political economy with the market economy. No longer are markets allowed to set out monetary allocations, they can only operate so long as they achieve the targets set forth by the central planners. Investors buy bonds not because of credit and payment characteristics, but at what price they can be sold back to a central bank. To make the right number of pencils, however, requires real knowledge of value and risk, and even the occasional outbreak of brutal market discipline.

The SMP's and LTRO's were supposed to be final interventions that would yield conclusive solutions, instituting economic and financial peace in our time. Instead we have seen nothing but escalation (the second largest mortgage lender in France failed this week). The monetary transmission mechanism is broken because monetary transmissions themselves supercede the free movement of capital and the free application of opinion. Judged from that perspective, markets have been right all along. Not only are those "evil" or "greedy" speculators breaking the elegant monetary transmission mechanism, they have been joined by ordinary people, retail depositors that are only seeking a way out of this constant price stability. Despite all this posturing and the sterilized balance sheet inflations, for all the financial innovation and technological advancement, it all merely proves conclusively that only the free market can allocate the right number of pencils.

 

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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