Last week, the ECB extended its monetary madness, pushing deposit rates
further into negative figures.
It is extending quantitative easing from sovereign debt into non-financial
investment grade bonds, while increasing the pace of acquisition to €80bn per
month. The ECB also promised to pay the banks to take credit from it in
"targeted longer-term refinancing operations".
Any Frenchman with a knowledge of his country's history should hear alarm
bells ringing. The ECB is running the Eurozone's money and assets in a
similar fashion to that of John Law's Banque Generale Privée (renamed Banque
Royale in 1719), which ran those of France in 1716-20. The scheme at its
heart was simple: use the money-issuing monopoly granted to the bank by the
state to drive up the value of the Mississippi Company's shares using paper
money created for the purpose. The Duc d'Orleans, regent of France for the
young Louis XV, agreed to the scheme because it would provide the Bourbons
with much-needed funds.
This is pretty much what the ECB is doing today, except on a far larger
Eurozone-wide basis. The need for government funds is of primary importance
today, as it was then.
In Law's day, France did not have a central bank, such as the Bank of
England, managing the issue of government debt, let alone a functioning
government bond market. The profligate spending of Louis XIV had left the state
three billion livres in debt, which was the equivalent of 1,840 tonnes of
gold. This was about 85% of the world's estimated gold stock at that time, at
the livre's conversion rate into Louis d'Or. John Law would almost double
that by June 1720, with unbacked livre notes issued by his bank.
Today, the assets being overvalued for the governments' benefit are
government bonds themselves, but the principal is the same. There is no need
to use a separate, Mississippi-style vehicle, because there is a fully
functioning government bond market.
Banque Generale created the bank credit for France's upper and middle
classes to buy Mississippi Company shares, driving up the price and making
yet higher prices a certainty. Law had set up a money-making machine for those
with a modicum of wealth, but the ten per cent down-payment required to
subscribe for Mississippi shares made speculation available to the servant
classes as well. The result was virtually everyone in Paris was caught up in
the speculative fever, and Mississippi shares increased from the 15 livres
deposit to 18,000 livres fully paid at the peak in June 1720. The term
"millionaire" dated from that time.
Today, the ECB is doing things a little differently, creating money to buy
government bonds from the banks, enabling governments to continue to spend
without the threat of a funding crisis. Basel III banking regulations, which
exempt banks from having to apply a risk weighting to government bonds,
ensures that the bonds are also in great demand as collateral, further
guaranteeing that the banks will continue to buy them.
However, in common with Law's scheme, the ECB needs new suckers all the
time to keep the market from stalling, so the ECB is extending the scheme
beyond sovereign debt by buying up investment grade bonds as well. And since
it can conjure up money out of thin air, it will also pay the commercial
banks interest to borrow from it, ensuring the yields on all bonds purchased
with this finance will continue to fall in line with negative interest rates.
As was surely the case in 1720, the expansion of credit is commonly
believed to be a very good thing, as necessary for the welfare of the
Eurozone states today as it was for France three hundred years ago. But don't
be fooled. For the scheme to continue, more credit has to be issued, and more
bonds bought to stop the bond bubble from deflating. That is the real reason
behind the ECB's action. And because it cannot be continued for ever, that is
why ultimately the bubble will pop.
The Mississippi bubble came to an end when France ran out of sufficient
buyers to keep it inflating. There always comes a point where the temptation
to cash in some profit to buy those other things long desired, such as a
country estate and a smart Paris residence, becomes too great to resist. And
when the Mississippi bubble lost its mojo, the selling escalated. By late
1720, the Banque Royale, as it had been renamed, faced angry note-holders
unable to redeem them for specie. Once the run started, the whole scam
rapidly imploded.
It seems extraordinary that in economics, wishful thinking trumps reasoned
analysis and common sense so often. The fallacies that have brought the ECB
to implement its delusional policies are broadly the same as those in which
John Law believed. In both cases, they started by assuming that the state has
a duty to ensure money and credit are freely available, unchaining the
population from the constraints of free markets. In both cases, their beliefs
inevitably adjusted as a result of problems that subsequently arise as the
by-products of monetary expansion. And in both cases, yet further monetary
expansion then became the only solution to apply as a cure-all for the
problems themselves. Unsound money has come to be deployed simply to keep
bankrupt governments going.
We should put to one side all other reasons, justifications and excuses
for what has happened, because it was the French state that employed Law to
run its bank, and the Eurozone governments that created the ECB. The servant
always serves the master. Banque Royale succumbed to a run, while the ECB is
still nursing a banking system, that on a reversal of the asset bubble, will
almost certainly collapse. In this respect, the ECB is not quite at the
Banque Royale's tipping point, but it is edging closer.
Everyone in the Eurozone believes that the ECB is all-powerful, because to
believe otherwise is unthinkable. This was also true of Banque Royale, until
it faltered. It was not a loss of confidence in the bank that was responsible
for the collapse, it happened as a result of the difficulties encountered in
sustaining the bubble. The lesson is that it need not take a loss of
confidence in the ECB to start its destruction.
Let's imagine for a moment, that the bond-market bubble ends and prices
start to normalise. We know that it won't take much to create losses that
will wipe out the capital of some critically important commercial banks, but
we like to think the ECB is on top of this problem. Very few people seem to
be are aware of the crisis that falling bond prices would create for the ECB
itself.
The ECB's equity capital at 31 December 2015 was €7.74bn, supporting a
balance sheet of €256.645bn, a gearing ratio of over 33 times. The wider
euro-system's accounts, where the asset purchases accumulate, has capital and
reserves of €98bn supporting a balance sheet of €2,872bn, a gearing ratio of
29 times and rising. As a rough guide, an interest rate increase of less than
two per cent, to as little as one and a half per cent, would undermine the
value of bonds and related risks at both the ECB and in the euro-system, to
the point where they would require further capital injections. For some
context, if the yield to maturity on a five-year bond rises by 2%, the price
falls roughly 10%.
Now we are getting to the truth as to why the ECB's debt bubble must be
sustained. It is no longer to support economic growth. A deflating asset
bubble will take down the ECB and the wider euro-system, just as the
Mississippi bubble took down Banque Royale. And in both cases, the confidence
vested in these institutions is reflected in the purchasing power of the
money they have issued.
It may not be long before foreign holders of euros begin to visualise Mr
Draghi in a full-bottomed wig, lace jabot and long velvet coat. Their problem
will be looking for safety, because the ghosts of eighteenth-century monetary
economists can also be imagined at the helm of the other major central banks.
In John Law's day, the solution was simple, as the private banker, Richard
Cantillon showed. He cashed in early, selling livres for gold.
Cantillon, who was the equivalent of today's investment banker, not only
punted the Mississippi bubble successfully, but he loaned large quantities of
fiat livres to the wealthy in Paris, taking in Mississippi stock as
collateral. Before the crash, he had the prescience to sell all his own stock
for gold. It is said that he also secretly sold all the collateral he had had
pledged to him, again settling for gold. Cantillon then removed himself
across the border to Italy with his stash of Louis d'Or to await
developments.
After the crash, he returned, and demanded repayment of the outstanding
debts from his clients. Cantillon probably became the richest commoner in
history, and immensely unpopular in Paris to boot. Rather like the investment
bankers of today, he made his fortune while nearly everyone else was
impoverished.
We cannot say for sure what will trigger the end for the ECB and the euro.
It could be a member state, like Italy, Spain or even France, running into
financial or political trouble. It could be the threatened break-up of the
European Union, if the Brexit polls swing in favour of Britain leaving, and
the blow that it would impart to European unity. The Muslim immigration
problem is often cited as a threat to the European project. It could be
developments on the other side of the world, perhaps China driving up
commodity prices, leading to future price inflation in the Eurozone, so
leaving Eurozone bond markets exposed to the threat of rising interest rates.
Equally, it might not be an identifiable event. Rather like the
Mississippi scam, it could end when the Eurozone's bond markets just run out
of steam.
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