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The ECB: Blind.

The ECB is supposed to promote financial stability in the Eurozone but you wouldn’t know it to look at their recent actions, or rather lack thereof. With M2 growth rates (M2 is a measure of money supply that captures pretty much anything that looks like a bank deposits) falling off a cliff, inflation rates faltering and crucially market expectations of inflation (which does the real damage) falling toward deflation, they have done precisely nothing this month to turn things around. In the 21st Century, we rely on the financial system extending credit to drive production. Money is created when banks lend and destroyed when they do not. As money represents claims on resources at some level, a falling money supply is interpreted by firms as a lack of demand (fewer claims are made on firms output) and economic activity can fall. The ECB therefore has a duty, as other central banks have done, to ensure that the financial system does its job and drives economic activity, and they are failing hard.

It’s not because the problem is insoluble. M2 growth rates in the UK and US have recovered to pre-crisis levels, and economic activity is recovering in those areas (despite a destructive contraction in government spending. This is because central banks in those places engaged in activities that, one way or another, enabled and made it profitable for banks to lend more. Safe assets like government bonds were bought with newly created money, which made those assets expensive and therefore undesirable, so banks sought new assets in order to make money. Lending to individuals was their chosen method, and consumer credit appears to be driving growth on both sides of the Atlantic. Whilst this may not be an efficient, fair or desirable way to boost economic activity, it at least has that effect.

 

The ECB however has failed to make safe assets unattractive, and Euro zone banks limp from liquidity crisis to liquidity crisis fearful of making loans. The Euro zone contains many countries that are perceived to be credit risks,  and because it has not done enough to guarantee that they will not go bust, their bonds still have relatively high yields. This means that any optimism by EZ banks translates into buying of these countries bonds rather than actually lending on to consumers, a problem that the ECB has completely failed to act on despite knowing that it is the case, and making frequent references to the problem of ‘financial market fragmentation’ in its press conferences. In his latest press conference, the ECB Governor went so far as to say that low EZ inflation and reduced yields in the periphery made him optimistic. Optimistic! Are we looking at the same numbers? Of course if there is a bit of stability peripheral yields fall because cagey banks start buying those bonds, but they’re doing that rather than doing the lending they need to do to get things moving.

Whilst this continues, we cannot have recovery. The financial system is broken. The ECB must act. They must put in place a robust programme of peripheral bond buying and signal to the market that they will not stop until peripheral yields are the same as those of core countries. They must provide unlimited liquidity to Euro zone banks and incentivise lending, by changing the rules around loans (capital adequacy rules and eligible collateral rules) to make them more attractive. They must also backstop peripheral governments by outright buying of bonds. Anything short of this will fail to solve the problem of a broken financial system dragging down economic activity. The US and UK have both done this, and the ECB must do it or consign the Euro zone to decades of economic misery, and more crucially, millions of lost years of human endeavour as the market is proving incapable on its own of supporting economic activity.

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