Debt, the ECB and Robin Hood

European Central Bank (ECB) President Mario Draghi and his band of Merry Men have it backward.

They’re supposed to imitate Robin Hood by stealing from the rich and giving to the poor. Instead, they’ve implemented a program that steals from the poor and gives to the rich, all in the name of saving the economy of the euro zone.

Of course, these days, that’s what central bankers seem to do best.

The implementation of a massive quantitative easing (QE) program by the ECB was talked to death over the past four months. At each ECB meeting the members would drag out the topic of QE, beat it up for a while, then decide to wait just a little bit longer.

At the same time, when members of the ECB gave presentations around the world, they were sure to mention how a bond-buying program (let’s not call it QE, because that would make people think they are printing money… which they are) would help lift inflation in the euro zone.

Given the theory of money in economics this makes sense, but given the reality of everyday life, it’s utter nonsense.

The Facts

In theory, a central bank creates money out of thin air and buys bonds from investors, banks, pension funds, etc. who already own bonds. This drives up demand for them, drives down interest rates, and puts more funds in the hands of the people who sold the bonds.

At this point, some portion of the money paid out for the bonds will end up as deposits at banks instead of being invested elsewhere.

So far, so good, but this is where things get tricky.

Lower interest rates are supposed to entice consumers and businesses who had been on the fence about borrowing money to pull the trigger. The lower cost of money (interest on loans) will suddenly be too much to resist, and they’ll jump at the chance to take on gobs of debt to buy more stuff (houses, cars, manufacturing plants, etc.).

At the same time, the huge influx of bank deposits is supposed to prod banks to make more loans.

If they sit on deposit balances, then they’re not earnrning any returnrn on lending, while they must pay depositors for their capital. The lower rate of interest just increases the urgency to lend because banks need every dollar of income they can get.

That’s the theory, anyway. Then there’s reality.

Banks in the euro zone, and in the U.S., for that matter, are not overrun with consumers and businesses that want to borrow. With minimal wage gains and aging populations, consumers across the euro zone are much more interested in preserving their wealth and standard of living than taking on new debt.

As for businesses, without a bunch of new clients, what’s the point in borrowing to expand? Even if a business sought new capital, it could borrow directly from investors by issuing bonds and bypass the hassle of bank loans.

As for banks needing to lend money so that they can make ends meet… that ship sailed a long time ago. Banks have been raising fees for years to make up for lost income on loans, and in the euro zone banks charge penalty interest on large depositors instead of paying them interest.

The upshot is that the domino effect of creating money to buy bonds, which entices borrowers to take out more loans and banks to make more loans, which puts more money chasing goods into the economy, thereby creating inflation and growth… does not work.

But there is one area that is a proven money maker — bonds.

Less Talk, More Action

While the ECB was gabbing about how it would initiate a bond-buying program in the future, traders around the world were busy scooping up bonds across the euro zone before the program got off the ground. Professional investors don’t simply use a portion of their funds to buy bonds, they use portfolio margin, which can give them up to 10 times leverage on their actual money.

By the time of the ECB’s announcement, Bank of America Merrill Lynch estimated that a full 25% of the $5.8 trillion governrnment bonds in the euro zone were trading at a negative yield. After the announcement, interest rates fell further, handing traders an instant profit on their positions.

This would be like directors of Fannie Mae (FNMA) telling everyone for months that they intend to buy homes of a certain size in a certain neighborhood, no matter what the price. If you could buy a home, or several, in that neighborhood with only 10% down, then you’d make a very tidy profit when FNMA finally started buying.

Of course, individuals don’t typically use portfolio margin, or any margin at all. The benefits of this almost entirely flow to professionals in the financial markets.

That being said, there is something left over for the lowly citizens of the euro zone — the falling euro. In the months ahead of the ECB announcement, the euro fell from $1.35 to $1.17. In the days after the announcement, the euro fell further, touching $1.11.

Again, this is part of the plan of the ECB, to drive down the currency so that exports are cheaper and more of them can be sold. The problem is that the positive effects are limited to exporting companies, and don’t necessarily flow down to workers and certainly not down to all workers.

But all consumers do feel the effects of a cheaper currency — it makes imports more expensive.

At the end of the day, the move by President Draghi and the ECB made traders richer and everyday consumers poorer.

Maybe the goal wasn’t to play Robin Hood, but the Sheriff of Nottingham instead.

Image RJ sig


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