Zero Rates Signal Total Economic Disarray, Not 'Stimulus'

Story Stream
recent articles

In November 2011, "inflation" in the EU was measured at 3.3%, while it was a touch lower for the defined "Euro area." Thus began both an age of great monetary experimentation and no appreciable effects on the one measure intended to "benefit" the most from it all. The ECB has engaged literally trillions in "stimulus" of almost every form imaginable, from buying covered bonds (instruments where banks own their own liabilities) to traditional interest rate maneuvers to simple and dramatic flooding the zone with LTRO's. And in that time, through all of it, the inflation rate in Europe has moved practically in a straight line lower, unalterable has been its trajectory no matter how much monetary officials claim power and authority.

What changed in December was the shift to zero. Unfortunately, as a means of interest rate mechanics nominal rates and yields all through Europe had already fallen to or below the mythical zero lower bound (which was only supposed to apply to overnight and ultra-short interbank rates, not the whole of yield curves down past the notes and into the bonds). Most of that was a consequence of those prior ECB activities, which shows that at least there was something to all the fuss.

But it was a naked almost collapse in "inflation" in December that sealed yesterday's long-sought QE. Spain had, despite all protestations of renewed economic vigor in 2014, felt the official HICP calculation fall from -0.5% in November to a "dazzling" -1.1% in December. And while Spain may have been discarded as a member of the structurally deficient PIIGS, Germany and France, the two heavyweights, both saw their numbers drop to 0.1% (and really zero). For the EU as a whole, the inflation rate fell from an already low 0.3% in November to the upsetting estimate of -0.2%

So the defined intentions of the unified central banking structure in Europe that began to seek out consistent inflation in late 2011 had finally seen it all arrive at the boundary between good and evil (in its own terms). A negative inflation rate is, of itself, not necessarily something that a central bank will overstate, however, a negative inflation rate as a result of 36 months of declining fortitude is something altogether more menacing (again, to central banks). There is no need to unnecessarily argue about where all this is headed, it has been three years in the making.

The precipitous acceleration, or deceleration as it may be, in December meant that events in Europe are approaching an even more elevated state of dysfunction; as if it were possible. Of course that includes the price of crude oil as a consequence of the fact that oil usage has so dramatically declined - on par with only the Great Recession. The timing of all of this falls under the "auspices" of the "dollar", a term I use in quotation as a matter of distinction since the modern "dollar" is nothing like the dollar.

There were repo problems in mid-June, as fails suddenly spiked with little warning. By the end of June, the "dollar" was rising in price, which is to say that the supply of mostly eurodollars had started to "tighten." For a world that is predicated almost totally on a synthetic short position of globalized stature, balance sheet tightening in eurodollars is a most unwelcome outcome. Whether or not there was a specific trigger to the vivid inflection in wholesale funding will take some time still to fully sort out, but I have my own eye on the ECB itself.

To anyone thinking that Europe operates as a separate system from the United States, this will come as a shock - as much of a shock as the 2008 panic started in 2007 in London. The road to illiquidity and then breakage was of European origin. The modern "dollar" standard unites far more than is appreciated by convention and traditional commentary. While European financial presence, especially Swiss, has declined in the years since the panic, it has not been erased by any stretch (with much shifting to an "Asian dollar short" to factor).

In early June 2014, the ECB pushed the envelope still further, bringing its nominal rate on the floor of its rate corridor down to -5 bps. It was the first time a major central bank took what was thought only a few years before to be an unspeakable action. The effect on credit markets was nearly immediate, as you might expect from such a major move. While there is no direct pathology implicating the ECB in the repo drama that almost immediately followed, the behavior of repo rates in the days just prior to, and then just after, the announcement of the corridor moves more than suggest a shift in funding stance.

In terms of a signal toward bank balance sheet construction, it was more of a confirmation of some lingering fears than the intended "boost" of "the ECB is loosening again." In other words, by taking a drastic step at that moment in the economic history of not just Europe but the rest of the world, the ECB had essentially admitted prior acts of monetarism had totally failed. The ECB still gets criticized for not being as "loose" as the Federal Reserve or certainly the Bank of Japan, but that is only by one metric of intrusive action. In many ways, the ECB's constant presence in the "markets" has been an overriding affair which made the monetary tragedy all the more striking - as they can't even keep their own inflation target from imploding no matter what they try.

In the wake of the QE announcement, there has been so very little accounting. Where did it all go? "It" sure never arrived where it was expected, in the real economy, instead, as I noted above, pushing sovereign bond rates right through the limits of positivity. Then there is the matter of European stocks at record highs while the economic landscape around them crumbles back into something more closely aligned with a constant seven-year depression.

But it is the eurodollar market that is most pressing and depressing. Undoubtedly through all the LTRO's and OMT periods some of those newly manufactured bank liabilities, not of ECB origin but rather influence, found their way into ballooning the balance sheet portion of the dollar-denominated world. The key ingredients in expanding "money" supply, even globally, are volatility and correlation. Correlation being brought upward is actually a positive when all is seemingly positive, as in the usual correlation skew is a benefit when everything appears to be brightening. If bank participants saw volatility falling in Europe, and elsewhere, as a result of the ECB's actions (alongside QE in the US) then finance was again awash in finance.

This was, of course, totally opposite the condition of 2007 all the way through 2009 (flaring again in 2010 and 2011). Correlation rising then was a matter of illiquidity acting upon pricing, creating a feedback effect which, combined with rising volatility, meant balance sheet constraints thwarting "dollar" function anywhere and everywhere. But it was Europe that took the initial steps into crisis, and then persisted within it when monetary authorities were dumbfounded by a geographical fragmentation that had never been evident or visible before. It was always there, but it took a major disaster for anyone to notice (and most still don't).

In February 2009, apparently completely unaware of the European flavor to all of it, Senator Phil Gramm defended his role in "deregulation" through the bill that bore his name, Gramm-Leach-Bliley (GLB). Writing in the Wall Street Journal:

"GLB repealed part of the Great Depression era Glass-Steagall Act, and allowed banks, securities companies and insurance companies to affiliate under a Financial Services Holding Company. It seems clear that if GLB was the problem, the crisis would have been expected to have originated in Europe where they never had Glass-Steagall requirements to begin with."

It's an amazing statement to have made as the crisis did indeed originate in Europe, though Wall Street participation was paramount. Being completely wrong about that fact does not necessarily prove the opposite point - that since the crisis started in Europe, GLB was to blame. However, the linkage to deregulation in the late 1990's is more than passing. There has been enough commentary, that either admonishes or absolves, describing some role of GLB in the Panic of 2008. In my estimation none of it actually deals with the process as a symptom, a symptom that echoed into the very existence of the euro itself.

There were more than enough waypoints on the path to GLB that indicated where banking was heading, as it had already thrown off a lot of the Glass-Steagall restrictions by the 1980's. However, much of that deregulation fails to focus on what actual regulations were replacing the ancient regime, namely Basel rules for banks and wholesale funding for the shadow portions of them. You could easily make the case that the amendment to Regulation M in 1990, officially sanctioning eurodollars, was as much responsible for the 2008 affair as GLB.

As I noted last week, there was a curious aspect to the second half of the 1990's that remains tied into the current climate. We know of the dot-com bubble and the housing bubble that followed it, but in almost every way except their end these imbalances were simultaneous. The stock market took its turn in valuations right in 1995 while home construction suddenly broke out of a four decade range in the early part of 1996. And right there in the middle of all of it were the Swiss banks, providing those "dollars" that achieved such a steady GDP "miracle."

Of course, it was not limited to the Swiss banks in eurodollar participation, the rest of European financials were just as represented. The resulting "fortunes" made from this vast expansion of finance simply made Wall Street envious for the lack of restrictions. And Wall Street did what any firm does in a heavily regulated environment, they lobbied for change. Of course, the financial lobby, as I said above, had been hard at work prior to even the explosion in eurodollars, but like the surge in stock prices there was a noticeable inflection in government "communication."

Throughout the period leading up to GLB, the word "compete" was used over and over as some kind of evidence for why the existing banking rules of the time were infeasible in this brave new world. The following appeared in an article for the Philadelphia Fed in 1996:

"One reason banks want to perform these activities is that they are profitable. As financial markets have become deregulated, banks have faced increased competition for their core businesses of deposit-taking and loan-making. In addition, technological advances have allowed firms increased access to funding from nonbank sources. Thus, finding new pathways to profits has become increasingly important for commercial banks, and it appears that underwriting securities is one such avenue."

In other words, deposit and loan-making were not "enough" of a business to let it all lie. While the author here looks to "underwriting securities" as the impetus for reform-driven profits, it was really the desire for tapping "funding from nonbank sources" as someone was already there taking advantage. By combining vast financial operations in every segment, deposit liabilities could be available to "fund" the rising securitization and liquidity aspects of the wholesale model. But first, that combination needed to be legal.

Citicorp took care of that in 1998 by practically daring Congress to do something, purchasing Travelers and obtaining a two-year compliance waiver from the Fed. It was not as if there wasn't support for deregulation, after all almost everything that was done in the two decades prior to GLB was bipartisan. Indeed, GLB passed the Senate 90-8 and the House 362-57. That dual-party commitment was similar to prior bills reducing the effects of Glass-Steagall, which only serves to heighten the attention as to why it took until the late 1990's for this final step. The allure of wholesale and shadow banking as the Europeans were doing it was, in my view, the last and biggest straw.

In many ways that was the same view as the Europeans themselves. From the perspective on that side of the Atlantic, the wholesale "dollar" system was likewise a lost opportunity. From the political point of view, European politicians saw very well what was happening in terms of global wholesale finance in "dollars." Their own banks, in what would be called the "hub and spoke" model, would gather local deposits and turn them into the means by which to participate in global eurodollar transactions (the very ability that Wall Street wanted to gain). So for Europe, that meant financial resources flowing outside (into a US bubble or bubbles) instead of remaining local.

That was a very strong element in the final gathering together of disparate financial systems into the euro currency itself. I don't mean to understate the political side of this, as that had been a trend a long time in the making and would have been pursued regardless of consequences, but I do believe that, like the ultimate passing of GLB, this wholesale finance issue was another "last straw" kind of factor. European politicians already set on the course could now argue that the euro would make such benefits - by challenging the dollar as a reserve currency, the euro would divert some of that overseas financialism and keep more of it home goosing domestic GDP instead of that in the US.

In May 1998, prior to the adoption of the euro and only a month after Citicorp took Travelers, thus igniting the deregulation debate in the US, former French foreign minister Jean Francois-Poncet gloatingly blustered, "A vast redistribution of the world's monetary reserves will follow, to the detriment of the dollar and to the profit of the euro, that will oblige the United States to share with Europe the privileges it takes from the international status of its money." Most people take "privileges...from the international status of its money" to mean pricing oil in local currency terms, but, just like the SNB's removal of its euro peg this month, there is an ocean-sized depth to the financial elements of the reserve currency "status." What the French and many European politicians really wanted was their own bubbles.

As history would turn out, Francois-Poncet was too eager in his estimation of the euro's ability to displace. Rather, the first head of the European Central Bank was more guarded about the prospects for a challenge to the dollar, but not the "dollar." Wim Duisenberg cautioned to "think here in terms of decades rather than years." To that end, the euro itself integrated in many ways not just Europe but also the "dollar." The introduction of this new currency to challenge the existing reserve framework ended up instead as a means by which financialism could simply explode everywhere.

In one sense, these activities in the latter half of the 1990's were a sort of financial arms race where "both" sides set about to outdo each other - which banking system could debase itself the fastest. In the end, they both did to a degree totally unthinkable when all of it was being debated. But in doing so it required cooperation across these divides, whereby the necessary product of liquidity was better maintained among all parties. It's almost as if the globalized banking evolution proved John Nash's great theorem of competition and cooperation.

The euro harmonized the banking system, at least to acceptable degrees, allowing European entrants into this "dollar" party that may not have been accessible under local currencies. Again, the depth of liabilities and the stretch of implicitness on the central bank in terms of perceived elasticity was vitally important to calculations and perceptions of volatility and correlation. From the American side, GLB guaranteed not just Wall Street participation, but also unleashing the tide of derivatives without which easy convertibility doesn't exist, as a consequence of the required risk-sharing (contagion?) capacity to obtain and maintain tremendous growth and that depth of liquidity.

As we see so vividly in 2015, such liquidity capacity isn't enough of a "fix" to intractable economic problems so much as it was altering on the economic function during the height of the bubbles (Francois-Poncet got his wish, only too much of it and not at the direct expense of the American bubbles but in tandem). The main monetary theory is that the real economy will follow its potential unless acted upon by some exogenous "shock." Should such a shock take financial origin, the task of the central bank is to alleviate it and allow the economy to return to its potential unfettered. To that end, the financial shock is always believed to be a factor of liquidity, which is why central banks keep acting in that manner.

Rather, the lack of actual effect of liquidity on the real economy of Europe (and the US, Japan, etc.) points to something else amiss. The ECB, like the Fed, had restored a sense of calm and order in financial "markets" through such heavy intrusions, so it stood to expectations that actual economic recovery would immediately and unambiguously follow. While it will escape the attention of central bankers on both sides, the "calm and order" in financial markets is only of appearances, and that deeper rifts remain unsolved.

The intrusion of this highly financialized system was really an artificial alteration of economic function globally. Instead of the "dollar" freeing banks to better "compete" what was instead introduced was a means by which to strangle actual and vital economic function through disastrous misallocation - something that had already been introduced in the age of fiat but was now amplified exponentially through wholesale "dollars." For its part, the euro represses the Eurozone in much the same way, as it is an ill-fitting design created not of organic processes to aid the economy as much as it was to circumvent them and fashion something in the will of its politicians (debt for the sake of debt, GDP for the sake of GDP). And through it all, the manner of the geographical divide between dollars and eurodollars was hidden amongst the euphoria of seemingly stable GDP and fastidious asset prices.

The end result of such highly destabilized systems is that they tend to consume themselves and fail. But central banks and economists operate under the assumption of discrete events unrelated by longer terms. In other words, the ECB somehow views the problem of today as of today rather than being seen, properly, as the practical outcome of many years of corrupting and artificial work. Indeed, these same people seem to believe that low interest rates, even as negative as they possibly can stretch, are somehow a positive factor for economic function when it is the opposite. Ultra-low interest rates are indicative of total economic disarray not "stimulus", and the further they depress across global yield curves the further from true economic salvation we all travel. Time value is supposed to be meaningful, but the seeds of the ultimate obliteration of time value were sown in the late 1990's concurrent to elected governments enthusiastically welcoming the first of the serial bubbles.



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

Show commentsHide Comments

Related Articles