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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.
Alasdair
McLeod
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