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The European Central Bank vs. Reality
The European Central Bank vs. Reality
April 30, 2012
Originally published in Real Clear Markets
The four-year charade of central bank bailouts is starting to come undone. Reacting to rising European bond yields in a Saturday meeting with world leaders, U.S. Treasury Secretary Tim Geithner called on the European Central Bank (ECB) to "aggressively" support Europe's insolvency as its various countries try to "stay ahead of markets." Blind to the sinking ship upon which he stands, he threatens to take everyone down with him by clinging to the false hope of monetary stimulus.
Europe's problem is the same as the U.S.'s - insolvency. The past 17 years have seen the greatest expansion of global credit in the history of the world. But this didn't happen because the world economy became more prosperous. While the world was sleeping, central bankers around the globe have been printing money to fuel the booms of the past two decades. The inevitable result will be an even greater bust than the current one.
The ECB has more than doubled the supply of Euros since its inception in 1999, according to OECD data. Interest rates have plummeted accordingly. The European interbank rate fell from 5 percent in 2000 to a low of 2 percent throughout 2003-05. Despite allowing it to gradually ratchet upward towards 4 percent in 2007-popping the very bubble created from the low interest rate policy of the mid 2000's-the ECB has since torpedoed the rate to stay below a rock bottom 0.5 percent.
What Geithner and the European Central Bank don't understand is that manipulating the interest rate through monetary policy has immense distortionary consequences. The interest rate is the price of borrowing money. The amount of savings in an economy determines that price. But when central bankers set an interest rate, they decouple the interest rate from savings and replace it with politics.
The problem with an artificially created interest rate lies in the disruption of a basic economic principle. Savings equals investment. Peoples' savings are an economy's source of finance. The interest rate rises as savings become more scarce and falls as savings become more abundant.
But the interest rate has fallen despite a shrinking pool of real savings. The Euro Area savings rate persistently decreased from 7.5 percent in 2000 to 5.8 percent in 2007. Europeans are saving less, but the interest rate - controlled by the central bank instead of by market forces - says they are saving more. This paradox is fatal.
Businesses take advantage of the lower interest rate to invest in long-term projects that would never seem like good ideas at their true prices. This is malinvestment. People aren't saving more of their income to finance these new business ventures. They aren't cutting back on present consumption to finance future consumption. In the boom, the businessman does not know that his previously unprofitable project was indeed unprofitable. The prices lied to him. This false optimism doesn't come from consumer behavior, but from a central banker's printing press.
Data from the OECD show a steady increase in the growth rate of Euro Area prices of capital goods - used for long-term projects - after the recession in the early 2000's until the 2008 crisis, when it plummeted. Eurostat reports steadily increasing consumer good prices during the same period. Despite declining savings and rising present consumption, Europe experienced greater long-term investment. This was not sustainable. Enter the bust.
The solution is to (pardon the cliché) stop the presses! Instead of being bailed out, malinvestment must be liquidated before Europe and the rest of world can hope to end the stagnation that almost two decades of excessive monetary expansion caused.
Political leaders and Eurocrats would rather the ECB dish out another round of stimulants so they can put off the painful restructuring they never allowed to happen in 2008. This cannot continue indefinitely. Despite printing over 1 trillion Euro since the crisis began, the Eurozone repeatedly faces financial turmoil through its weakest link: the periphery.
Trying to beat markets is a losing game. Geithner and his European cohorts have yet to realize that. As central bankers continue to expand their balance sheets in pursuit of an impossible goal, they worsen the impending crisis during which their mistakes will be corrected.