Down Debt

The European Central Bank is trapped. Here’s why.

Several of the major central banks are caught in a trap of their own making.

This includes the US Federal Reserve, Bank of Japan, European Central Bank and others.

The credit-based global financial system that we have built and participated in over the past century must continually grow or die. It’s like a game of musical chairs to which we have to keep adding people and chairs so that it never ends.

Indeed, the accumulated debts are much larger than the total supply of currencies, which means that there are more demands for currencies than there are currencies. As such, too many of these claims can never be allowed to be called at once; the party must always go on. When the debt is too large in relation to the currency and starts to be called, a new currency is created, because its production costs nothing but a few keystrokes.

It’s like this for most major countries:

Debt versus cash

Chart source: St. Louis Fed

In other words, demands for dollars (debt) are growing much faster than the ability of the economy to generate dollars and are much larger than the amount of dollars that exist. When this becomes too problematic, the amount of base money is simply increased by the central bank.

Base money is a liability of the central bank and is used as a reserve asset by commercial banks. Broad money is the liability of commercial banks, and it is used as a savings asset by the public. Treasury bills are liabilities of the federal government, and they are used as collateral by the central bank and commercial banks.

In other words, liabilities are secured by other liabilities, all the way.

To learn more about this:

Central banks are placing guardrails on either side of this credit growth, trying (and often failing) to ensure that it doesn’t bubble up too quickly or collapse into a spiral. default deflationary. They want steady credit growth with maybe a few soft cycles along the way and a steady 2% average annual devaluation.

For decades, whenever economic growth was slow, central banks cut interest rates and encouraged more credit growth (i.e. debt accumulation), leading to surges. of economic growth. Whenever the economy was booming, they raised interest rates and discouraged credit growth, to try to calm things down.

The problem is that this level of micromanagement, knowing that the core system would always be bailed out if needed, has contributed to ever-higher levels of debt relative to GDP, both in the private and public domains, and to increasingly low interest rates.

Over the past four decades, the increase in debt over time has always been offset by reductions in interest rates, so the the cost of servicing this debt never really increased.

Eventually, however, the major central banks all reached zero or even slightly negative interest rates, and there was not much to drop. Any further increase in debt at this point would be difficult to offset with lower interest rates. The cost of servicing debt relative to GDP and income would actually start to rise.

Moreover, if ever the world were to experience a significant decline in productivity, for example due to de-globalization or the under-investment in raw materials that we are currently experiencing, the resulting inflation would be difficult to offset by interest rate increases.

Interest rate vs. inflation

Chart source: YCharts

We haven’t seen this level of disconnect between inflation and interest rates since the 1940s, which is the last time sovereign debt as a percentage of GDP in the developed world was as high as it is today. .

So, just like in the 1940s, many central banks in developed markets are trapped. They can’t raise interest rates persistently above the prevailing rate of inflation, and instead are stuck with slowly rising interest rates, eye-popping forward guidance, yield curve control and attempts to inflate some of the debt.

However, the European Central Bank has arguably the most difficult task of all.

This was very clearly seen at the head of the ECB Christine Lagarde recent maintenance.

He was asked, “how are you going to drive down the balance sheet?” while viewing the ECB’s balance sheet on a screen.

ECB balance sheet

Chart source: Trading Economics

She replied, “It will come. It will come. In due time it will come. »

The interviewer paused, confused, then asked, “…how?”

And she answered, “In due time it will come.” And then smiled.

She offered no response, no description, no clarification and had rather awkward expressions throughout the exchange.

Indeed, like most central banks, there is no plan. It won’t come. Sovereign debt will be monetized to the extent necessary, otherwise it will collapse. And for the ECB, it is particularly difficult, because it has to monetize the debts of certain countries more than other countries.

A monetary union without a fiscal union

Eurozone countries have given up their monetary sovereignty. Instead of keeping their own currency, they agreed to use a common currency, and therefore a common central bank.

It had advantages and disadvantages, but due to the way it was structured, it was politically unstable from the start.

The United States can unilaterally print dollars. Japan can unilaterally print yen. Their governments can strongly influence their central banks as needed. But Italy, for example, cannot unilaterally print euros or heavily influence the ECB on its own.

At first glance, it doesn’t seem that different from the US states. Texas, California, New York and other states cannot print dollars. So what’s the problem if eurozone countries can’t either?

Well, the difference is that the United States mostly has a shared fiscal union in addition to a shared monetary union, whereas Europe generally does not have a shared fiscal union.

American states share most of the same pension, rights and defense systems. Residents of all states pay into Medicare and Social Security, as well as the US Armed Forces, which collectively make up the vast majority of federal government spending. Citizens of the United States are not citizens of any particular state; they can move freely around the country under what is mostly the same system of rights. On the other hand, these rights systems differ greatly from one European country to another.

In the end, it is the difference in indebtedness due to this lack of fiscal union that counts. European countries had higher debt levels when they became a monetary union, and they have only increased since.

Here are the top five US states by GDP, in terms of government debt as a percentage of state GDP.

  • California: 5%
  • Texas: 3%
  • New York: 8%
  • Florida: 3%
  • Illinois: 7%

And here are the top five European countries by GDP, in terms of national debt as a percentage of their national GDP:

  • Germany: 70%
  • France: 113%
  • Italy: 151%
  • Spain: 118%
  • Netherlands: 52%

The percentages for US states and European countries can be further increased if we take into account off-balance sheet duty liabilities that are expected to occur in the future. These are essentially debts that have not yet been marked to market.

But however we calculate it, there is a gaping difference between the debt levels of US states and the debt levels of European countries. In the United States, public debt is mostly at the federal level rather than the state level, whereas in Europe, public debt is mostly held at the individual country level, and they don’t have individual central banks with a unilateral ability to create base money.

This shows how difficult it is to compare the situation on this point. Most US states do not need Fed monetization of debt to remain solvent. At some point, some of them might face pension fund insolvency, but that’s not such a structural problem. Several European countries, however, need persistent monetization of debt by the European Central Bank to remain solvent year after year.

To be clear, the United States has a host of problems. I’ve written many articles about how the petrodollar system has undermined American manufacturing more than the rest of the developed world, for example. Unlike Europe, the United States has run a structural trade deficit for decades and has a very negative net international investment position. The United States is also more financialized than Europe in the sense that our stock market is large enough to affect our economy rather than the other way around. We are so consumer-driven, equity-driven, and dependent on the foreign sector recycling our trade deficits into our capital markets, that “the tail may actually be wagging the dog” in that direction.

But in terms of the specific ability to cease sovereign debt monetization for periods of time, this is where the ECB sits near the bottom of the pack compared to other central banks. This is a more complicated political question.

Robin Brooks, chief economist at the Institute of International Finance, and former chief FX strategist at Goldman Sachs and former senior economist at the IMF, has some of the best charts to illustrate this question. The solvency of Italian sovereign debt is in the hands of an entity, the ECB, over which Italy exercises no unilateral control:

Monetization of Italian ECB debt

Source: @RobinBrooksIIF

In the long term, I can’t imagine being a European investor and having significant long-term exposure to the currency, especially in some southern European jurisdictions.

I would much rather have real estate, profitable stocks, commodities, gold and bitcoin, than euros and eurobonds. The same is true for the US, Japan and other countries, but with Europe the currency comes with additional tail risks, especially now that their energy security is under serious pressure.

The euro against gold

Chart source: YCharts