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Protocol 12: The Case Against European Central Bank Easing

Dan McReavy - 18/01/2015 11:16 CST

Brussels, Brussels Hoofdstedelijk Gewest, Belgium

Global investors are in a position to be deeply disappointed by Mario Draghi and the European Union.  Permanent Open Market Operations (POMO), or quantitative easing (QE) as it has come to be known, have been a standard business practice of central banks since the free floating currency regime emerged in 1971 following the Nixon Shock event.  The general public is generally confused as to what does and does not stimulate an economy as well as why low interest rates are dominating the debt curves of the primary global reserve currency issuers.

According to Articles 121, 126, 136 and Protocol 12 of the Treaty on the Functioning of the European Union (TFEU), all member countries are bound by treaty to constrain deficit spending and debt to GDP ratios.  Therefore, any expanded POMO or announced QE program will have no meaningful fresh supply of EU member debt to purchase and, thus, will not be stimulating to the European Economy.

As the 75th Secretary of the US Treasury once said, it's a matter of "political will".  Instead of parsing every utterance from Mario Draghi, everyone should be listening to the Council of the European Union for indications of a real European stimulus package.  Until the EU seriously expands the supply of EU-member debt, one can expect European credit to be scarce and well-bid holding nominal yields down.

For further commentary on this subject as well as how the US Federal Reserve arrived at the quantitative easing policy, continue reading.

Since the extraordinary set of events that climaxed in the Fall of 2008, investors around the globe have been either infatuated or infuriated by former Chairman of the US Federal Reserve Benjamin Shalom Bernanke's introduction of the quantitative easing financial regime.  As the world has understood quantitative easing, Bernanke was printing money which many people believed - with maybe a few solvent believers remaining - would lead to hyperinflation that many failing government structures throughout history have experienced when tampering with their currency supply.

In reality, Benjamin Bernanke extraordinarily expanded the Federal Reserve's Permanent Open Market Operation (POMO) purchases.  It wasn't long ago that POMO transactions were unsexy and something only Central Banks, Primary Dealers and the Bank for International Settlements paid any attention to.  In effect, POMO purchases would create collateral for the expansion of the currency supply and POMO purchases were viewed as an indicator for actual money printing.  Right now, US currency holders have the best collateral situation ever with the Federal Reserve's massive multitrillion dollar portfolio of government and government-backed financial assets.

The official narrative that the Federal Reserve held interest rates low with quantitative easing is really a half-truth when one compares fluctuations of US Treasury yields and the timing of announced changes to the quantitative easing operations.  For interested parties, the key periods  to look at on a chart of the 10 or 30 year US Treasury would be approximately: March 2008, February 2010, November 2010, July 2011, October 2011, September 2012 and January 2014.  Reviewing these periods one will observe that interest rates tended to rise on the announcement of a commencement, purchase increase or continuation of quantitative easing while interest rates tended to decline on the announcement of a cessation or purchase reduction of quantitative easing.

At first blush, one would conclude that the Federal Reserve seems to have increased interest rates while promoting they were buying with both hands to reduce everyone's borrowing costs.  Can you figure out what the key ingredient was to make Bernanke's statements true and what has driven financial assets to extreme valuations in the face of collapsed commodity prices?

If you said the supply of US Treasury debt, give yourself a smiley sticker.

The Federal Reserve is the US Treasury's bank and banks are in the business of selling and managing loans as well as acting as a trusted third-party intermediaries for financial transactions.  Banks don't print money and neither does the Federal Reserve; the US Bureau of Engraving and Printing is charged with printing the money.  Technically and legally, the Federal Reserve didn't print or mint one shiny Abraham Lincoln-faced cent - and never has.

The events of 2008 revealed a cavernous multitrillion dollar hole in the general public's financial asset column of the collective private sector balance sheet.  The home builders had built all of these homes and the banks sold all these fancy loans to everyone and then, on the margin, no one could buy or sell a home as people stopped making mortgage payments on loans they could no longer afford and banks' assets, loans, turned into non-performing loans and massive liabilities.

This was not mankind's first encounter with non-performing loans and, historically, these financial contagions have been addressed by altering the terms of the contract, bankruptcy reorganization, or by modifying the supply of the loan contract's currency, currency debasement.  Ever since the late Richard Nixon shocked the world and closed the Gold Window on 15 August 1971, the dollar has been free-floating in *PRICE* against all of the world's many goods, services, assets and other currencies.  

The dollar's *VALUE* is derived from its ability to support commercial transactions locally, nationally and internationally and its *PRICE* is determined by the dollar's supply relative to the other currencies competing with it for commercial transactions around the world.

With the US dollar being the largest reserve currency in the world, the US has had to innovate a capital structure, investment complex, for all of the US dollar holders to exchange their idle cash, savings, for so that everyone else can use the dollars to increase commercial activity for the benefit of everyone.  In ordinary times, people love the capital appreciation that stocks can generate compared to the "fixed income" returns of bonds.  In extraordinary times like the world experienced in 2008, people only care about safety and the return of their capital and,  as events have played-out so far, the safest place to hold your money is cold cash or in bonds guaranteed by a powerful government.  With a military and tax collectors, governments are usually the last parties to go broke when the economy cools.

In the Fall of 2008, the global economy was ice cold and everyone holding money wanted to sell their stocks and buy US Treasuries - and, at the same time.  This caused stock markets to crash and the US Treasury market to boom as people were willing to pay ever-increasing prices for safety.  This panic selling of stocks and buying of US Treasuries and hoarding of dollars caused there to be an insufficient supply of US Treasuries to meet the global demand and, since interest rates move opposite of bond prices, interest rates plummeted to new lows.

With a multitrillion dollar hole in the US dollar financial system and a now rapidly-contracting global economy, the US Government had two basic options:

One, the US Government could stand aside and let the private contracts work themselves out according to their agreed upon terms through the legal system, or, two, the US Government could negotiate deals with all of the world's lenders to fill the multitrillion dollar hole in the balance sheet.

In the case of basic option one, the US dollar is the largest reserve currency in the world and there are governments, banks, business and people everywhere on earth that would, for all practical purposes, see their dollar-denominated financial assets become worthless.  Forget the ramifications of making a foreign government with a military mad, America's general public would have become ungovernable and riotous in due time.

So the second option was really the only practical option, and the impossibility of negotiating with each individual creditor necessitated a recapitalization deal that was boilerplate and as fair as possible so that funds could be easily administered and promptly disbursed.  The financial system was recapitalized through TARP, but the economy was plagued by businesses with no orders and customers with no money to make new orders.

This was another problem so large and complex that only the US Government could take a shot at solving, but they did.  The American Recovery and Reinvestment Act of 2009 was drafted and passed which established the US Government as both the borrower of last resort as well as the consumer of last resort.  In total, the US Government would run a $1.4 trillion dollar deficit that would create a $1.4 trillion dollar surplus for the private sector so that everyone could begin a long road to recovery.

The most basic rule of accounting is that debts must equal credits on the journals, ledgers and financial statements.  So if the US Government is going to run a $1.4 trillion deficit where would the $1.4 trillion come from and how would the world account for it to balance the books?

Not only would printing that much money require a lot of ink and special paper, but it would diminish the value of the already circulating dollars and promote an underground cash economy.  If everyone was short of money, who could afford to buy the $1.4 trillion of newly-issued  US Treasury supply.  No one, kinda.  What made more sense was for the US Government to direct the Treasury to borrow the money through the issuance of new US Treasury bonds.

Benjamin Bernanke, Chairman of the US Federal Reserve, stepped in and suggested the expansion of the Federal Reserve's Permanent Open Market Operations to buy the massive supply of US Treasuries and simultaneously balance the books in a legal and orderly way that would preserve the status quo.

The rest is history, but what about Mario Draghi and the European Central Bank?  Why isn't the ECB buying massive quantities of member bonds through an operation equivalent to the US Federal Reserve's POMO?

The answer is that the European Union is a political union of 28 different countries.  The European Monetary Union also exists within the EU framework, but not all 28 countries are participants and not all countries are equals.  The most financially-powerful members of the European Union are Germany and Greece.  Germany is the most powerful because it has the strongest economy and the most reserves.  Greece, on the other hand, is powerful because it is economically and financially very weak.  Greece has the non-trivial capability to not only sever its status as a member of the European Union, but also to default on its financial liabilities as a member of the European Monetary Union.

Over the next two weeks the world not only waits and speculates on what actions the European Central Bank will announce, but the world also awaits a Greek snap election that could have irreversible implications on the fate of the European Union itself.

On the trending topic of whether Mario Dragh, President of the European Central Bank, will announce his own version of Benjamin Bernanke's quantitative easing program, I think we first need to answer the most important question before we talk about the financing:

Will Germany allow the European Union members to run massive deficits and, more importantly, run a massive one itself?

In my estimation, no.  

Germany is fiscally conservative, but of greater significance is that the Euro has been in hot pursuit of the Japanese Yen and Russian Ruble and is already very weak against the US dollar.   The weakness against the dollar makes European goods and services cheap in the international market and, I believe, will prove to be a sufficient stimulus to the European Economy without saddling the entire European Union with a single additional euro of debt.  A massive expansion in the supply of Euro-denominated credit would have a crushing effect on the price of Euros in the international forex markets.  At some point I would not be surprised if Germany did some minor deficit spending of its own to push their short-term interest rates nominally back above zero, but Angela Merkel is still the face of Germany and as long as she is there Germany will remain staunch fiscal-policy conservatives.

The Euro will likely continue trading lower against the dollar as the day of Mario Draghi's announcement approaches and I believe that, should the European Union not undergo a Bernanke-sized quantitative easing operation, the supply of Euros will look relatively thin to savvy onlookers who will be quietly buying and vigorously pointing to the political fires in the EU.

To be certain, the European Union's problem is the same problem that the Concert of Europe faced which is that Europe may be easy to point out on a map, but good luck selling the idea that British people are the same as Germans or that French are the same as Italians or that the Dutch are the same as Greeks and everyone should cover each other's checks.

In the weeks ahead, I will be watching for signs that the savvy onlooker is buying Euros and Euro-denominated financial assets while the tired legacy media promotes the imminent demise of the European Union to drive European financial assets holders to sell before it's too late.  On some future dark day, the European Union may collapse, but I don't think that day will come in January 2015 no matter what any of these politicians do with respect to deficits, bond purchases or Greece.  Governments are like big ships and they take a long time to make very wide turns.