Alasdair Macleod – 11 April 2011
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.