The ECB is right and the Fed is wrong

By Edward Harrison On Jul 4, 2008

Monetary policy has never been so interesting. With price increases in food and energy causing upheaval around the globe, citizens of the world are crying out for policy makers to get a handle on inflation. Yet, the global banking system is on the verge of collapse as the worst credit crisis since the Great Depression has been lingering over the global markets since August.

On the one hand, you have inflation, which would suggest interest rates need to move higher. On the other hand, you have systemic risk in the banking system, which becomes more threatening if rates move any higher.

What should a central bank do?

The ECB has decided to raise rates, whereas the Fed has decided to stand pat. The ECB is right and the Fed is wrong. Here’s why.

The ‘natural’ rate of interest for interbank lending (as expressed in the open market by LIBOR or Euribor) is much higher than either the Fed Funds rate or the ECB base rate. This means that both the Fed and the ECB are running a loose monetary policy in order to aid the banking system and/or dampen the shock of the present economic downturn. The Fed’s policy is much looser than the ECB’s. These monetary policies are ill-advised because they are inflationary, distort the economy, create a disincentive to save and invest, and will ultimately lead to a greater bust down the road.

In order to prove my point clearly, let me expand on how the banking system works and what the central bank can do to manipulate it. This is a long, but thorough post.

The purpose of interest rates
Consider money to be just like any other good. Therefore, a loan is essentially an exchange of a ‘present good’ (money that can be used today) for a ‘future good’ (an IOU -money that can be used later). Because people will always prefer having a good straight away than receiving that good later, the present good commands a premium in the marketplace. That premium is the rate of interest.

Interest rates, therefore, represent the time value of money. It is the mechanism through which individuals express ‘time-preferences’ i.e., how much more they value receiving money right now as opposed to a later date. The premium of present money over future money fluctuates according to people’s time preferences; if people want money today very badly, the premium for money today (interest rate) will be high.

So, the purpose of credit and interest rates is clear. It is the mechanism by which one is compensated for deferring consumption today for later consumption.

The business cycle
Loans on credit also create the boom-bust business cycle. In our fractional reserve deposit banking system, banks must keep on hand only a portion of the money we deposit. The rest is lent out as credit. Therefore, if all depositors were to rush to the bank to redeem their deposits, the bank would not have enough cash on hand and would be declared insolvent. This is what happens in a bank run. To avoid a run, banks must maintain the confidence of depositors by acting prudently and cautiously in extending credit. If not, they risk insolvency.

The problem is that human nature steps in; as the business cycle progresses, the banks lend more and more money. Naturally, some of those loans are ‘bad’ loans i.e., the debtor cannot pay back the full principal at the required time. The banks must account for these bad loans in their loan loss reserves.

However, at some point, when the credit cycle has progressed too far, one of two things occurs:

The economy ‘overheats’ and inflation starts to rise. Whispers start circulating that the central bank will raise interest rates and that inflation is spiraling out of control. The central bank does increase interest rates and many loans that looked good in a lower interest rate environment start to go sour.
Banks simply start lending to too many questionable debtors and more loans go bad than anticipated.

As rumors circulate that this bank or that bank has been lending imprudently, the banks dig in their heels and pull back. Interest rates go up, credit contracts, and the economy goes into recession.

This is the business cycle. It is a natural part of our capitalist system and it is entirely created by the extension of credit.

Manipulating interest rates
As we just saw, the problem in the real world with interest rates is that at the end of business cycles, sometimes the natural preference for present money over future money is very high. This means interest rates are high; high interest rates restrict credit. And our capitalist system (of fractional reserve banking using a fiat currency issued exclusively by a central bank) is founded on credit. Generally speaking, individuals do not like to see credit restricted because it slows consumption and makes the economy seem ‘weak.’ That means recession.

What to do?

Inflate. They can inflate in two ways.

1. Lower interest rates. Basically, the central bank must lower the base interest rate. In the U.S., this is the federal funds rate, the rate at which banks can lend to one another the mandatory deposits that all banks must make at the Federal Reserve. These deposits at the Fed are mandatory in order to underpin the banks’ deposit base so that they remain solvent and trustworthy, thus preventing a run. By lowering the base rate, the central bank is altering time preferences, thus making it more favorable to lend.

2. Increase the money supply. The central bank also injects money into the economy by writing a check on itself (as the central bank is the sole issuer of legal tender). It then pays for assets (usually government bonds) with this previously non-existent money. Once this money is deposited by the counterparty’s bank as a mandatory deposit at the central bank, the result is a larger deposit base against which banks can lend. Just to repeat: the central bank creates money out of thin air and uses this money to pay for assets, thus increasing the available deposit money against which banks can issue credit.

Manipulation is bad
The problem with an inflationary monetary policy is that it ignores the natural time preferences inherent in the marketplace. Economic agents are saying one thing about interest rates and the central bank is overruling that in order to meet its economic agenda. What then happens is economic agents receive false price signals and lend based on those signals. Production based on those false signals eventually is found to be unwanted and the loans go sour. So not only do we still have all of the previous dubious credit outstanding, we have just added more credit on top of it, making the problem bigger still.

When George Soros talks of a 25-year super bubble, this is what he means. The Fed has been using easy money as a palliative for the last 25 years in order to reduce the pain of recession. As a result, debt has been building in the system for 25 years as credit expands ever more. The unwinding of this credit bubble is that much more painful because of the magnitude of debt outstanding. (See Chart of the day: U.S. Household debt, Chart of the day: Debt to GDP).

Central banks obviously hope to ease the pain of the recession by lowering interest rates temporarily. The thinking here is that the central bank can raise them and restore economic balance once the worst of the recession is over. The central bank hopes time is its friend. This largely worked after the 1990-91 recession in the U.S. in that the Fed eased. Yet, debt levels decreased through the recession as
a good chunk of excess credit was worked off.

The present squabble over interest rates
So that brings us to the present squabble over interest rates. Inflation has been rising and some believe a wage-price spiral is a significant threat. Past doctrine dictates that this would be the time for an aggressive move against inflation. But, while the ECB has raised rates because of inflation, the Fed is up to its old tricks of providing easy money to soften the blow of recession.

Yet, debt levels in the U.S. are much, much higher now than they were in 1990. In fact, they are the highest ever. Obviously, the easy money of the past has encouraged excessive credit in the U.S. economy and led to this dangerous situation. Why would the Fed think that more easy money would do the trick?

Money is obviously easy because of the huge differential between LIBOR and Treasuries (the TED spread is 95 bps). Fed Funds and LIBOR serve largely the same function. Why are they so different? Wikipedia says this:

Though the London Interbank Offered Rate (LIBOR) and the federal funds rate are concerned with the same action, i.e. interbank loans, they are distinct in that:

The federal funds rate is a target interest rate that is fixed by the FOMC for implementing U.S. monetary policies.

The federal funds rate is achieved through open market operations at the Domestic Trading Desk at the Federal Reserve Bank of New York which deals primarily in domestic securities (U.S. Treasury and federal agencies’ securities).^[4]

LIBOR is calculated from prevailing interest rates between highly credit-worthy institutions.

LIBOR may or may not be used to derive business terms. It is not fixed beforehand and is not meant to have macroeconomic ramifications.^[5]

-Federal Funds rate, Wikipedia

Basically, the Fed manipulates Fed Funds and, thus, treasury rates. But LIBOR is largely determined by the market (although it has been proven to be artificially lowered by market manipulation, so the TED spread should actually be greater).

Solvency versus liquidity
Fed apologists claim the Fed must not raise rates because of the potential systemic risk this could create. Ambrose Evans-Pritchard goes so far as to claim that the ECB, in raising rates, is re-creating a Great Depression scenario. But, what these pundits fail to discern is the difference between providing liquidity in an illiquid market and propping up insolvent banks with easy money.

Anshu Jain, head of global markets at Deutsche Bank, agrees that the credit crisis is “by no means over.” However he says this about what is happening today:

Jain declined to predict when the crisis will end. He described the U.S. Federal Reserve’s decision to provide a “liquidity backstop” for securities firms as a critical step. The main difficulty banks are currently grappling with has to do with solvency rather than ready access to cash, he said.

“Banks continue to need and raise equity capital, and the proportion of equity capital which is required is directly driven by the further drop in assets they own,” Jain said. “One of the assets which continues to be in free fall is U.S. house prices.”
–Economic Times, 4 Jul 2008

Solvency is the issue here, not liquidity.

Conclusion
The answer to the interest rate dilemma is clear. Central banks should not inflate, but should lend at market-appropriate natural rates of interest. To the degree they need to provide liquidity, they should do so at penalty rates of interest. Institutions that cannot deal with this state of affairs are obviously suffering from a case of insolvency, not illiquidity.

The Bank of England said as much last year. However, when Northern Rock, a bankrupt institution that had made too many bad loans, went to the wall, the BoE caved in to political pressure.

The Federal Reserve has also succumbed to political pressure, while the ECB has not. Ultimately, the ECB has chosen the right path and the Fed has not.

Related articles
How The Bubble Bursts, Mr Practical, Minyanville, 2 Jul 2008

Suggested reading
The Case Against the Fed, Murray Rothbard
America’s Great Depression, Murray Rothbard
The Austrian Theory of the Trade Cycle, Ludwig von Mises
What Has Government Done to Our Money?, Murray Rothbard