Interest rates and Plan B
The ECB’s interest rate increase
last week has been heavily criticised because it makes
the rescue of the PIIGS more difficult. It might however
turn out to be a sensible move: the rate increase and
the one or two that will surely follow should actually
have a restricted impact on the funding problems round
Euroland, while the ECB bolsters its anti-inflation
reputation. Furthermore, this and further small rises
over the course of the year give cover for the ECB to do
things that don’t make headlines, particularly with
respect to extending credit to insolvent banks to keep
them from going under.
The Fed can now be expected to
follow suit, to steady the dollar, and because a middle
way between simplistic alternatives has to be found now
that zero interest rate policy (ZIRP) has more or less
run its course. One of the stark alternatives is to end
quantitative easing and permit far higher interest
rates, plunging the Obama administration into bankruptcy
and the US economy into deep economic cleansing. The
other is more ZIRP plus QE3 resulting in accelerating
stagflation, made worse by a rapidly depreciating
dollar. So a middle course between these two has to be
chosen very carefully.
The debate over this looming crisis
is deeply unsympathetic to the real issues facing the
Fed. Commentators seem unwilling to appreciate there is
much going on behind the scenes that drives actual
policy, and that Bernanke, Trichet and King are in
constant communication in these difficult times. Critics
seem unable to understand the central banks’ primary
concern, which is not inflation: it is keeping
over-leveraged insolvent banks afloat through a period
of private sector credit deflation.
The problems facing the
fractional-reserve banking system have worsened since
the Lehman crisis, but bank solvency is rarely the
headline story. In the US, nearly 25% of households have
zero or negative net worth, compared with 18.6% in 2007.
Home values have fallen by $6.3 trillion since 2005.
Last year, 12.5% of households had at least one member
unemployed, and household debt has reached 136% of
average household income[i].
These statistics warn us that if the American economy
doesn’t recover, there will be a home-grown banking
crisis. Furthermore, the banks themselves are becoming
complacent, having tucked away losses with the
connivance of the Federal Accounting Standards Board.
Out of sight has become out of mind, and as long as the
Fed can produce the cash flow by buying debt at
artificial prices, why worry?
It is however naïve to think that
the Fed is unaware of the fragility of the domestic
banking system, and it is also naïve to think that
central banks have no co-ordinated plan to deal with a
major banking crisis. They will have examined any amount
of what-if scenarios, from a derivatives melt-down to an
old fashioned bank run spreading throughout the system.
They will have worked out plans together to respond to a
full-blown crisis. And you can bet short odds that the
major central banks are being very careful with interest
rate policy while the system is so fragile, which is why
it is unlikely that the ECB’s increase last week was
enacted without careful consideration.
Obviously, this has increased the
pressure on the Fed and the BoE to raise interest rates
sooner rather than later. Furthermore, the Fed and the
BoE are having their hands forced by the unstoppable
rise in gold and silver prices. This is a suppression
scheme the central banks have finally and demonstrably
lost, and in doing so the mounting costs of the short
positions on Comex and in the unallocated accounts of
LBMA members have become a serious systemic risk. And
rising commodity and energy prices show the Fed’s ZIRP
to be inflationary and no longer appropriate. The Fed
would have preferred to wait for more evidence of
economic recovery before raising rates, but it no longer
has that luxury.
The reality is that the Fed is
fighting a losing battle, but it must continue the
fight. The Fed has delayed the end of ZIRP as much as
possible by spinning the myth that core inflation is
still low. The point has arrived when the Fed should
take the initiative and increase interest rates by a
first small step. This would be designed to take the
steam out of gold and to help stabilise the dollar,
thereby reducing inflation concerns. At the same time,
it will make little difference to both banking and
government funding costs.
Doubtless, the Fed will be accused
of having to raise rates because of the ECB’s rate
increase. The reality is that the Fed will have known
about the ECB’s rate increase well in advance and has
been prepared to abandon ZIRP at the appropriate time. A
virtue can be made from a necessity: the end of ZIRP
will act as a passport for the Fed to continue with
quantitative easing programmes, because even with a rise
in Treasury yields, no one else is going to fund Obama’s
deficit. The Fed’s monetary policy will come into line
with the ECB’s: raise interest rates as little as
possible, while bailing out both government and the
banks through the banking system. And above all, pray.
With the end of ZIRP the
over-riding economic objective has to be to stop the US
from sliding into depression. It is still the economic
locomotive pulling the western train: if the locomotive
fails the train stops. Any time purchased by
money-printing allows us to continue to travel in the
hope that recovery is round the corner, otherwise the
banks’ balance sheets will start to contract in earnest.
The share prices for Bank of America and Citigroup, for
example, indicate that these banks, which are both major
components of America’s financial system, are unable to
take much more financial stress. And if you discount the
puffed-up statistics on unemployment, inflation and GDP,
the US private sector is actually sinking. But US
interest rates can probably be raised by a few small
steps without too much damage, so long as QE programmes
continue to fund the deficit.
This time-purchase scheme is bound
to fail eventually, if the system is not undermined by a
black swan event first. But again, we can be reasonably
sure that the ECB, Fed, BoE, BoJ and other important
central banks will have developed contingency plans for
this event. Indeed, only today the UK’s Independent
Commission on Banking has proposed that the banks
ring-fence domestic banking from non-domestic banking.
This will ensure that lines of credit, deposit accounts
and the cash machine network will continue to operate in
a systemic crisis. It is the only practical strategy for
keeping money circulating in the domestic economy in a
banking crisis, and you can be reasonably sure it has
been pre-agreed with the Bank of England.
This strategy makes sense, but the
implications should be thought through. The plan implies
that in a financial storm domestic banking activities
would automatically pass into public control. This would
be politically popular; the unpopular bit would be to
preserve the fat-cat end of the business. However, the
strictly financial activities of banks are also
necessary for the survival and operation of high-street
banking, so they have to continue uninterrupted as well.
This can be achieved both practically and politically by
giving the task of rescuing international and investment
banking activities to the central banks.
Thus we have the makings of a
global Plan B, to be implemented if a black swan arrives
or the US economy fails to recover. Will it save the
banks? Possibly, but the price will be an acceleration
of money-printing to save the system and then pay for it
if the plan fails. Above all, Plan B will prevent an
economic collapse occurring through a lack of paper
money. And because economists like Dr Bernanke have
dedicated their working lives to preventing the
deflationary alternative, it is time for him to go for
Plan B and raise rates by one quarter of one per cent.
11 April 2011
