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A post-Keynesian ECB!

From: Erwan Mahé (guest post)

Our longstanding readers are used to my strongly critical assessments of the ECB’s policies in recent years, which have often been viewed as contrarian. Unfortunately, the decisions the central bank has taken have either come too late or have been flat out bad for the European economy, and that’s leaving aside the unwillingness of the ECB’s governors to exercise their full mandate. Today, I promise to never rehash those unhappy episodes, because I believe that our central bank has finally and conclusively changed course!

It appears to have undergone its very own Copernican revolution by abandoning a geo-centric view of the universe based on gold standard thinking in favour of a heliocentric model whereby it is recognised that commercial banks are the ones that create money, not the central bank, and in rejection of the Bundesbank’s favourite indicator, M3. All the measures announced yesterday, for which we have been arguing over the last several weeks, reflect this new philosophy. For some of us, this turnabout represents a huge step forward in the eurozone’s future.

Even the refusal to launch a true quantitative easing, for which many of have clamouring, is to be applauded, as we explain below. As for the icing on the cake, you will see how another measure, relating to collateral eligibility, which has been totally ignored by commentators up to now, is one of the most important ones! So let’s take a look each of these decisions and non-decisions under the lens of our Post-Keynesian microscope.

The lowering of benchmark interest rates

Spot on, the negative -0.10% depository facility and +0.15% refi rates were largely expected. Only the cut in the 35-bps marginal lending rate to 0.40% was greater than expected.

We can only applaud this lowering of the marginal rate, given that it is the main benchmark lending rate used by national commercial banks within the framework of “Emergency Liquidity Assistance” (ELA) and that it is highly relied upon by the banks from the most distressed peripheral countries. The ELA totals are still about €57.4 billion, after peaking at € 206.3 billion in 2012.

However, I would like to insist on one big issue that has been largely misrepresented by many commentators. The point of cutting the deposit rate into negative territory is NOT to force commercial banks with excess reserves to lend to the “real” economy. Commercial banks do not control the amount of excess reserves (base money); only the central bank has such power

Let’s examine a case in which a bank with excess reserves lends a certain sum to a client rather than depositing it with the ECB in order to generate a positive interest rate (yield) (based on a loan rate of between 2% and 3%), instead of paying a negative rate to park its money with the ECB (-0.10%). The loan amount is thus credited to the bank account of the client in question, which leaves the commercial bank in a position of excess reserves! The bank thus retains the excess reserves until the client spends the loan amount. But that assumes that the end recipient of the client’s spending has his account at another bank, which amounts to simply shifting the money from Bank A to Bank B.

In terms of aggregate levels, the banking system can therefore not get rid of excess reserves in the system, whether or not it grants loans to the real economy.

Only the central bank can navigate these reserves on a systemic level, not just by sterilisation operations, but also by regulatory measures, because it set the percentage of reserves required of banks as a function of their client deposit amounts. These reserve requirements are remunerated at the refi rate, which is now 0.15%.

The ECB thus arbitrarily bloated the amount of excess reserves in the system when it decided on 18 January 2012 to lower its reserve requirements rate to 1% of deposits, which compares with the 2% level it had been at since the ECB’s creation in 1999. It is worth noting that some countries, like Canada, Great Britain, New Zealand, Australia and Sweden operate with no reserve requirements at all! These countries put the prudential emphasis on the banks’ capital ratios, which jibes much more with the reality of a modern currency than does the celebrated “money multiplier” myth.

So, you may ask, why bother lowering the depository rate into negative territory, if the measure does not encourage lending to the real economy?

The reality

Although obviously not acknowledged, there are two reasons for the move to negative interest rates. The first is to act on the euro exchange rate.

By crushing the short part of the yield curve, the ECB is trying to narrow the gap between US and European yields on this segment of the curve, which have been widening since the beginning of the year, with higher Eonia rate volatility, whilst the Fed Funds remained stuck at 9 bps. This narrowing of the yield spread between the US and the eurozone was thus confirmed, as the yields on German treasury bills declined from 0.15% to 0.01%. An artificial prop for the euro exchange rate is evaporating.

Moreover, the lowering of the deposit rate into negative territory will, at last, require the “manipulator” countries to pay for the privilege. These counties accumulated (and, in some cases, continue to accumulate) stocks of euros in order to stop the appreciation of their own currency vis-à-vis the euro. These countries, and Switzerland is a case in point, were offered the luxury of depositing their euros in the ECB’s deposit facility so that they could end their purchases of short-term German debt at any price. Indeed, at the worst of the eurozone crisis in 2012, these countries dragged German rates of up to 3 years maturity into negative territory, which self fed the panic, said rates being inversely correlated with those of peripheral countries.

Now that the scenarios of the eurozone’s breakup have lost credibility, it has become less risky to require that these beggar thy neighbour countries to “pay in order to play”. And then, try to restore the monetary policy transmission channel. One of today’s main problems on the eurozone is that the low level of rates set by the central bank over the past two years has not been uniformly transmitted throughout the eurozone. The lending rates granted to German SMEs are thus well below those granted to their rivals in the peripheral countries.

Of course, there are a number of other constraints at work here, including the lower qualified credit demand in the economies under life support with the capitalisation problems of some local banks, especially during AQR periods. But the ECB’s research show that, at equivalent credit quality, the SMEs in peripheral countries pay much higher financing costs than their peers in the “core” countries. And that’s where we return to the principle of our modern currency. This gap is also due to the disparity of the interbank market such as we knew it before the outbreak of the Great Financial Crisis. This market is necessary for the circulation of deposits created by bank loans to balance the banks’ balance sheets. However, since the outbreak of the Great Financial Crisis, the unsecured part of this market has evaporated, with the cash-rich banks, mainly from the core countries, preferring to deposit their excess reserves with the ECB instead of taking the credit risk, even on the overnight segment, with banks deemed to be struggling.

With its decision to impose negative interest rates on these cash-rich banks, the ECB is working a niche that can only please us: the nominal illusion dear to the behaviourists! We earlier examined this nominal illusion in the case of “sticky wages”, and I am ready to bet that we will see the effect in this case.

It is indeed a much easier for a bank treasurer to tell his board that he deposits the bank’s cash at the ECB at 0% to avoid risks than it is for him to justify the writing of a check to the ECB each evening for exercising this same privilege. After all, the check comes directly from the bank’s earnings. It will be very tempting to place these excess reserves elsewhere, on an interbank market or a repo market, at the risk of taking a new counterparty risk, even if the yield is absurdly low, with an Eonia at 7 or 8 bps.

Here we are, it’s Friday evening and I would like to send you today’s Thaler’s Corner before you leave for the weekend. I will send more text Monday. I fear it will be a very slow day (yes, markets are open!), so I will have plenty of time to write on the following topics:

The end of the SMP sterilisations

In order to accentuate the effect of the negative deposit rate and a victory for the post-Keynesians


Very good news for lending to SMEs

 The lowering of the benchmark rates

Very good news for lending to SMEs

 The easing of collateral criteria

The real bonus from the ECB’s meeting, which has been completely ignored by analysts.

No QE and ABS programme

Here too, despite the consensus view, this is really good news

  1. June 6, 2014 at 9:02 pm

    There is not much to disagree on statements about the mechanics of monetary manipulation in this article. But it is a confused speculation on the purpose and impact of the manipulation. Punish currency speculators? Create money illusion? “NOT to force commercial banks with excess reserves to lend to the “real” economy” but “very good news for lending to SMEs”?

    Draghi has explicitly stated that the measure is to “address risks of prolonged low inflation”. But the measure may actually lead to stagflation: asset price inflation and economic stagnation. It is part of the Phillips curve fallacy that higher inflation lead to lower unemployment. The relationship has been refuted, repeatedly and substantively over time, by data from many countries. Inflation is a wealth transfer mechanism, not a wealth and employment creation mechanism.

    • F. Beard
      June 6, 2014 at 9:53 pm

      Inflation is a wealth transfer mechanism, Yes

      not a wealth and employment creation mechanism. No, No.

      Or do you think mining gold under a gold standard* does not create wealth and employment?

      *Which is unethical btw, since inexpensive fiat is the ONLY ethical money form for government debts, cf. Matthew 22:16-22.

      • June 7, 2014 at 1:06 am

        Inflation is not the production of goods and services and hence does not create products or wealth or employment.

        Inflation transfer wealth to the recipients of new money at the expense of holders of old money through the Cantillon effect.

        Gold mining produces gold and employs miners and therefore creates wealth and employment. Gold mining does not imply a gold standard, which is separate from the issue of ethics.

        Fiat currency gives economic power to a government which may or may not be ethical. In fact, that power has invariably been abused by governments e.g. to wage unnecessary wars.

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