August 6, 2016

The Sovietization of Money

On August 5 the Wall Street Journal reported (p. C1 print edition):
Central banks have a new favorite tool for boosting lackluster growth: corporate-debt purchases. Two months after the European Central bank started buying corporate bonds, the Bank of England announced Thursday that it would adopt a similar strategy. ... The move, investors and analysts say, is likely to drive down borrowing costs even further around the globe for large companies already benefiting from ultralow interest rates. 
This program comes on the heels of the ECB's Public Sector Purchase Program (PSPP), a European version of the Federal Reserve's much-criticized Quantitative Easing. The PSPP, in turn, comes on the heels of the ECB's 2014 treasury bond buyback guarantee, where the bank promised to purchase any amount of bonds issued by any euro-zone government.

Before the buyback program the ECB used a backhanded method back in 2012 to funnel boatloads of money to governments with runaway deficits and credit ratings in tailspin. They forced financial institutions to borrow money from the ECB and then buy treasury bonds with that money. The ECB loans were cheap, interest rate was high on bonds from countries like Greece, Spain and Portugal, and financial institutions made good money.

In other words, since 2012 the European Central Bank has used at least four major policy initiatives to flood the eurozone with newly minted cash. The corporate bond purchase program is only the latest expression of what increasingly looks like a monumental monetary-policy failure on behalf of the ECB.

All these four steps - the backhand, the buyback, the PSPP and the corporate bond purchases - are examples of stimulative monetary policy with the purpose of lowering interest rates and capping and reducing the costs of risk. As risk-taking becomes less costly, the hope is that entrepreneurs and investors will find it worth the while to expand and invest. 

The problem is that over the past four years the euro-zone economy has not seen any recovery in real-sector activity. Consider Figure 1:

The increase in euro-zone GDP growth from early 2012 coincides in time with the start of the ECB's extremely relaxed monetary policy. Part of that growth has to do with increases in exports from the euro zone, which in turn are driven in part by the sluggish recovery in the U.S. economy. But even if all of the growth increase since early 2012 were the result of the opening of the monetary floodgates, the common-sense question would still be: is it worth it?

The first step, the backhanded funneling of money through financial institutions to governments with serious credit problems, was not primarily aimed at generating new real-sector activity. Its first and foremost purpose was to secure funding of the welfare states in countries with galloping deficit problems. This was not enough, however, to stabilize the finances of those governments, so the ECB added its bond buyback program. In effect, this program removed altogether the risk of investing in bad-credit welfare states. 

While this brought some stability to the deficit-funding of the most troubled members of the euro-zone it also set a precedent for the future. When created the ECB was strictly barred from monetizing deficits in individual member states. Nowadays, the ECB is not only profusely pumping money into treasuries around Europe, but has also begun doing the same to private businesses.

The program for buying private bonds is a step up and above anything that monetary policy can ever have said to be designed for. In addition to the usual arguments about government picking winners and losers, there is the fundamental problem with the destruction of the liquidity system in an economy. 

Put simply, "money" in a modern economy is a wide range of assets from cash to real estate. Not literally, of course - nobody carries a skyscraper around in his pocket to be able to pay for something he wants to buy - but in the form of a transferrable ownership certificate. We call them "shares" in companies or "bonds" in someone's debt. We also call them "credit lines" when we can borrow money against all kinds of assets. (Today, even the title of a used car can be turned into cash in only a few minutes.) 

Most of the money we have is not even carried as cash. It comes in the form of a debit card with a certain amount of purchasing power; a credit card with someone else's assets that we have been given the right to use; etc. The amount of money we carry around this way - and that we have access to by putting up equity as collateral - is dependent on several different factors. One of them is our own earnings: the more we make and put into our checking account, the more we have available on our debit card. If our credit rating improves and we pay our annual credit-card bills, we are granted access to more of someone else's money. As the value of our house increases we can borrow more against it.

Not one of these means to increase our access to money is dependent on the central bank's monetary policy. They are the result of private actions on private markets. Our ability to make more money depends on our hard work, our professional qualities and the demand for our kind of skills on the job market. The limit on my credit card depends on my actions and how they are evaluated by a credit-card company. The price of my house is determined by the real-estate market in the city where I live.

The thinking behind the ECB's private-bond purchase program is that there is, somehow, a lack of liquidity of some sort in the private sector. They think that by offering to buy bonds from private companies they provide liquidity that, when provided, will go straight into productive investments that, in turn, will kickstart real-sector activity.

The problem is that private businesses get access to money in precisely the same way as the rest of us do: they make it by selling more of their products; they are granted access to more credit for having sound finances; and their stocks are valued higher on the stock market, whereupon they can issue more stock and raise more money that way.

However, in all these three instances there has to be someone else in the other end who is willing to give something to the business. In the case of a stock IPO someone has to be willing to buy that stock; in order to believe in the profitability of investing in a new IPO, the stock buyer must have reasons to believe that the business he is investing in will make more money in the future. The same is true with expecting more revenue from sales - and de facto from expecting a higher credit line. Someone has to buy your products or believe that you will have bigger sales in the near future. 

Turning this reasoning around, the point becomes: if confidence exists, a business will have access to more liquidity thanks to bigger sales, higher credit lines and demand for more of its stock. 

In other words, if the economy is doing well the business does not need cash from the central bank. 

If the central bank still insists on buying corporate bonds, does that help the business make more money? No. As we just noticed, a business operating on a healthy market with lots of activity will see its credit score increase; as a consequence, the cost of financing its investments will go down. It will not need the ECB's cash.

Put bluntly: the ECB's private-bond buying program is the answer to a question nobody asked. 

Worse than that, though, it is actually a step in the direction of Sovietization of money. There, the central bank had effectively taken over the funding of private-sector activity by printing new cash to pay for everything from construction projects to payroll. They did not realize that money is a carrier of value - not value in itself. 

By stepping into the private-bond arena the ECB is also taking a step in the direction of Soviet-style monetary policy. Once they can fund one kind of private-sector credit, then what is to say they will not get into the real-state business? What about mortgages? Car loans? Personal credit?

If the ECB does not stop and reverse its program, it will open a Pandora's Box of artificial credit. At the end of that road lies the complete destruction of the credit system that has been a backbone of free-market capitalism for two centuries.

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