I.
The latest wave of financial-market turmoil has been caused in particular by growing investor concern about the financial health of commercial banks, especially banks in the eurozone.
It seems that investors have been increasingly losing confidence in banks’ ability to live up to their payment obligations under “normal” market conditions and to generate sufficient profits going forward.
Such an interpretation may contribute to explaining the depressed valuations of eurozone bank stocks, which have lost around 71 percent of their value since the start of 2007.[1] In contrast, losses for US bank stocks amounted to (just) around 50 percent.
II.
The current level of “stress” banks find themselves in — especially in the form of rising costs for obtaining funding in the market place — may be illustrated by two variables:[2]
- The spread between the 3-month Libor interbank market rate and the overnight index swap (OIS) rate; and, for eurozone banks,
- the so-called EUR/USD cross currency basis swap, which shows the cost of US-dollar funding for eurozone banks by borrowing euros and converting them into US dollars through an FX swap.
The graph below shows the spread between the 3-month money-market rate and the OIS in the eurozone and the United States in percent from 2007 to the start of 2012. Since around August last year, the spreads have been creeping upwards, especially in the eurozone, reflecting rising investor concern about banks’ financial health.
However, spreads have so far remained well below their peaks seen in September/October 2008, when the US investment bank Lehman Brothers defaulted. Back then, elevated spreads indicated that investors feared that the collapse of the US investment bank could drag down the whole (international) banking sector.
Since then investors have learned that central banks will provide banks with any amount of base money needed to keep them afloat. Indeed, the US Federal Reserve (Fed) has ramped up banks’ excess reserves to close to $1.5 trillion, while in the eurozone the European Central Bank (ECB) has raised it to close to €700 billion.
This, in turn, has led to a decline in credit, or default, risk in bank debt denominated in domestic currency from the viewpoint of investors: under the current monetary policy of providing unlimited amounts of base money, investors can expect to receive their nominal money invested in bank debentures and deposits.
Lately, however, eurozone banks have come under increasing pressure as far as their US-dollar funding is concerned. Private investors are only willing to extend US-dollar credit to eurozone banks at elevated interest rates, if at all.
The development of US-dollar-funding costs for eurozone banks when taking recourse to a cross-currency basis swap can be seen in the graph below (for one-year maturities). The more negative the value becomes, the more expensive it is for eurozone banks to obtain US-dollar funding. In fact, funding costs have been returning toward the peak levels seen in September/October 2008.
III.
This development led major central banks around the world to take coordinated action. On November 30, 2011, the Bank of Canada, the Bank of England, the Bank of Japan, the ECB, the Fed, and the Swiss National Bank (SNB) announced that they would provide unlimited amounts of base money via liquidity swap agreements “to support to the global financial system.”[3]
The announcement included a lowering of the already-existing US-dollar liquidity-swap agreements of 50 basis points down to 50 basis points and extending these arrangements to February 1, 2013.
In addition, central banks announced that they would provide “temporary bilateral liquidity swap arrangements, so that liquidity can be provided in each jurisdiction, in any of their currencies should market conditions so warrant.” All central banks have thus effectively opened the gates for churning out any amount of base money required to keep banks in a position to pay their obligations.
By such action, central banks are signaling that they stand ready to take over banks’ refinancing in whatever currency: should investor demand for bank obligations fail to “return to normality,” central banks will fill banks’ funding gaps with newly created base-money balances.
This is actually what happened in 2008/2009, in a situation of severe market stress, when the Fed’s US-dollar liquidity swaps to other central banks reached nearly $583 billion in December 2008.[4] With a decline in the market stress level, banks repaid base-money balances to the Fed.[5]
IV.
The increase in the base-money stock is far from being neutral. First and foremost, an increase in the (fiat) base-money supply is inflationary: it lowers the purchasing power of a money unit (below the level that would prevail had the money supply remained unchanged).
It benefits the early receivers of the new money at the expense of those receiving the new-money balances at a later point or not at all — as explained by the so-called Cantillon effect.
Such a rise in the money supply prevents market prices from adjusting to their true levels. For instance, if central banks extend additional base money to banks, the latter do not have to, say, sell assets (loans, securities, etc.) for refinancing purposes.
As a result, asset prices are being kept at prevailing (artificially elevated) levels. While banks and other asset holders enjoy a windfall profit, other investors are prevented from having the opportunity to buy assets at lower prices.
While a policy of increasing the base-money supply might avoid immediate output and employment losses by keeping banks afloat, preventing them from defaulting on their liabilities, the important question is whether such a policy will help restoring the economies back to health.
From the viewpoint of the Austrian School of economics, the answer is no. Ludwig von Mises showed that a boom-induced fiat money — and today all major currencies represent fiat money — can only be kept going by further and further increases in fiat money (or fiduciary media), created through bank circulation credit expansion, leading to artificially lowered market interest rates. He wrote,
A credit-expansion boom must unavoidably lead to a process which everyday speech calls the depression.… The depression is in fact the process of readjustment, of putting production activities anew in agreement with the given state of the market data.[6]
However, if it is the political goal is to prevent a depression — that is, a decline in the money stock due to defaulting banks and debt in general, accompanied by falling output and prices and rising unemployment — at all costs, ever greater amounts of debt will have to be monetized by central banks.
A policy of unlimited increase in the base-money supply, if consequently pursued, would ultimately lead to a drastic debasement of the fiat currency. It could even lead to what Mises called a “crack-up boom” (in German: Katastrophenhausse), entailing the destruction of the fiat currency.
At some point,
The crack-up boom appears. Everybody is anxious to swap his money against “real” goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap paper. Nobody wants to give away anything against them.[7]
[bio] See [AuthorName]’s [AuthorArchive].
[comment]
You can subscribe to future articles by [AuthorName] via this [RSSfeed].
Notes
[1] Another factor may be investor expectation of forthcoming rights issues, which would dilute the value of holdings of existing shareholders. In an extreme case, investors may even fear the possibility of banks getting nationalized.
[2] See Goldberg, L. S., Kennedy, C., Miu, J. (2011) Central Bank Dollar Swap Lines and Overseas Dollar Funding Costs, in: FRBNY Economic Policy Review, May, pp. 3- 20.
[3] See, for instance, the press release of the SNB „Coordinated central bank action to address pressures in global money markets” from 30 November 2011.
[4] For the impact on the eurozone see Vergote, O., Studener, W., Efthymiadis, Merriman, N. (2010), Main Drivers Of The ECB Financial Accounts And ECB Financial Strength Over The First 11 Years, Occasional Paper Series, No 111, May, esp. pp. 17–19.
[5] Banks held also elevated levels of base-money balances over year-end, which contributed to the demand for base money. The program expired on 1 February 2010 (with the latter denoting the last day for initiation of a liquidity swap).
[6] Mises, L. v. (1996), Human Action, 4th ed., Fox & Wilkes, San Francisco, p. 563.
[7] Ibid, p. 428.
