The ECB's Free Money

26 Dec 2011    

News: European banks flock to ECB's free money (Bloomberg)

The European Central Bank has a responsibility to keep the banking system functioning, and it has decided to do that by offering banks very cheap long term loans. In fact these loans are so generous that Bloomberg and others have described them as "free money".

Of course there is no such thing as free money, free money is just a magic trick that shuffles the money about, and if you watch what is going on carefully enough you see it just a sleight of hand trick that benefits one at the cost of the other. In this case what we are really talking about is a transfer of wealth to European banks from everyone else. This kind of operation is inequality promoting because "the ripped off lied to little people" don't have the skill to hedge against inflation, nor exploit financial anomalies, and the spread between their mortgage rate and the "risk free rate" widens dramatically. Italy is famous for its historical use of negative real rate inflationary policy, and it's also famous for wealth inequality. But the situation today is much more serious, because back in the 1970s before financial liberalization this kind of policy did somewhat negatively effect the wealthy, whereas today it's purely beneficial. So this action is like giving the rich a money printing press, and shutting the little people out of the party, and increasing the margin the rich earn on the little people's loans. You can hear them all outside screaming as we pop open the champagne bottles, and we lean out of the window and say "don't worry it will trickle down!". Those of us who run hedge funds in Switzerland are laughing all the way to the bank, but the journalists and politicians who are supposed to represent the people's interest and are now breathing a sign of relief at the stabilization of the banking system don't think about the long term picture. They don't realise that the trickle down is an illusion, it's actually a completely trickle up operation that is just making things vastly worse.

Newspapers complain that austerity costs jobs, they say look at the USA - it's growing at 2%-3% per year racking up debts instead of implementing budget cuts, so stimulus is the logical choice. That's typical of democratic decision making, there is no though for the future, whatever feels good is the "logical choice". A word that is suddenly fashionable in the West today is "pragmatism", but in a world in which everyone is using a sort of moral compass to make decisions pragmatism is a disaster, because the power of pragmatism depends on the ability to see far into the future. For example, Stalin called himself a pragmatist, and he did get very good short term results, but if you look very far ahead, his terror destroyed both the communal idealism and the professionalism of the Russians, so when the pressure was lifted by Khrushchev everything rapidly unravelled. How can we describe modern economic policy? There are two policy leavers, fiscal policy and monetary policy, and two targets, inflation and growth; and when policymakers think about these targets they are thinking no more than about a year into the future; and none of their forecasts work, nor do they have real idea how much they should pull these levers. Do you see this is a recipe for disaster?

The crisis reminds me of story told by Plato. The Great Philosopher Tharles was walking along one day studying the stars looking upwards when he fell into a pit. An attractive and witty Thracian serving girl jeered at him for being so eager to know the things in the sky that he couldn't see what was before him at his very feet. It's a joke about philosophers who are so long sighted and starry eyed they come across as bumbling idiots or mat hatters in ordinary conversation. Yet the crisis today brings to mind another vision. It makes me think of great statesmen crawling in the dirt, studying the consistency of soil through microscopes like the medieval doctors who studied stool samples. They turn an inch to the left and an inch to the right looking for the optimal path, but the crisis just keeps getting worse. A Thessalian witch screeches why didn't you Emperors of Wisdom turn left three hours ago, can't you see you're driving the mule train into a volcano. There's a yell from the crowd "the emperors are wearing no clothes", then a hail of laughter, then a sudden violent shift in the mood.


From an old article of mine:

Figuring out how to handle both the insolvency of Fannie and Freddie, and major banks such as Lehmans, is one of the major issue of today. Personally I do not approve of the UK's Northern Rock Nationalization which protected unsecured bond holders and is likely to cost the tax payer money. At the same time allowing Lehman's to fail was absurd because the FED could have saved it and made a profit by writing off both the shareholders and bond holders during a compulsory nationalization...

What I would be tempted to do is start nationalizing failing banks, writing off both shareholders and bond holders, which would cascade through the entire banking system, but would leave ordinary depositors protected. As a result the government would end up taking possession of almost the entire banking system for nothing, and in ten years time it could sell all the banks back to investors, meanwhile lending would not shrink because the state owned banks would not have to cut risk. What I am describing is a slightly more aggressive version of the 1991/92 Swedish banking rescue, yet there is an even more radial option available - don't re-privatize. Some have suggested the power to create new money, which is an integral part of the fractional reserve banking system, is simply too dangerous to be left in private hands, and we need a largely state owned banking system.

In Plato's Republic one of the financial reforms Socrates suggested was choosing the market traders, the financial intermediaries facilitating the efficient exchange of goods, from amongst the least warrior like and least quick witted members of society. Socrates wanted the financial system to be as simple and boring as possible. For example, instead of targeting inflation or growth I would consider setting interest rates to prevent financial anomalies such as the currently negative real rate for cash which is so hopelessly out of line with rising real asset markets and which consequently drives inequality and inefficiency. Socrates even said the commodity prices should be stable and shouldn't fluctuate, so goods simply run out in times of shortage instead of rising in price, and I think that he has a point here we are missing today.

Now if your goal is to make the financial world boring, for example much more like the way it was from the 1950s up until the 1980s, the innovative vibrancy and risk appetite of the private sector is the very antithesis of your needs, and a state owned financial system is the ideal solution.


Was the starry eyed visionary Socrates right? Think about his suggestion made 2,500 years ago that "we choose financial traders from amongst the least warrior like and least quick witted members of society".

In Jan 2009 Lord Turner said: "the years running up to 2007, too much of the developed world’s intellectual talent was devoted to ever more complex financial innovations, whose maximum possible benefit in terms of allocative efficiency was at best marginal, and which in their complexity and opacity created large financial stability risks"

How amazing is that? That's what I call long sighted.