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...If Trichet is clever, he will move the ECB to slower money creation once US and British real estate prices have stabilized. That will allow Eurozone interest rates to rise moderately, while remaining lower than the crisis rates in the Anglosphere. Then he will be able to contrast the problems in the US and Britain with the favorable outlook for Euro zone inflation under his Presidency of the ECB.
For a French intellectual, particularly an ENArque, proving such superiority to the Anglosphere is always the most satisfying outcome of all!"
The future of the credit crunchBy Martin Hutchinson
December 24, 2007
SourceMartin Hutchinson is the author of "Great Conservatives" (Academica Press, 2005) -- details can be found on the Web site www.greatconservatives.com
Observers of the credit crunch that has been bedeviling financial markets since August were mostly highly relieved this week when the European Central Bank injected some $500 billion into the world’s banking system via low cost funding and the Fed followed up with $40 billion of its own. This sharply lowered the premium that interbank deposit rates have commanded for the last four months over Treasury bill rates. However in the general rejoicing that the international financial markets were not about to ruin everybody’s Christmas, one question has so far been ignored: How in hell are the ECB and the Fed ever going to get their money back? The financial fate of the world’s taxpayers, as well as the future of the markets themselves, rests on the answer to this question.
The amounts of money involved here are pretty staggering. The British taxpayer’s cash injection into the Northern Rock scam now exceeds 25 million pounds, with another 30 million pounds in guarantees, which combined total has more than doubled even the Labour government’s budget deficit if accounted for properly (it is about 2.3% of Britain’s Gross Domestic Product, a not insignificant amount of money to pour into a wholly insignificant financial institution.) Needless to say, there seems no prospect of the taxpayer getting more than about half of this sum back.
As for the European Central Bank’s $500 billion, that represents approximately 5% of the Euro area M2 money supply. Admittedly it represents less than six months growth in M2, since that aggregate is growing at the disgracefully rapid rate of 11.2%, almost double the growth rate in nominal Euro area GDP. Nevertheless an addition of 5% to the euro area’s money supply has to be inflationary, even if much of it leaks back to the United States, which is itself pursuing an excessively expansionary monetary policy.
Unlike the much predicted but in the event mild inflation produced by the Fed’s excessively stimulatory monetary policies of 1995-2007, this additional injection of liquidity may result in a much sharper and more rapid burst of inflation. However that inflation is likely to appear, not in the euro area, blessed with a strong currency and an even trade balance, but in the United States, whose chronic and gigantic balance of payments deficit has so far had no discernible effect.
The ECB, Fed and British bailouts involve an even a more serious problem than inflation, which is the question of repayment. The $540 million has been lent to the banks in order that they not suffer a shortage of liquidity at year-end. However, while the need for liquidity is less after January 1, the underlying condition of the assets being financed will not have changed and may even have got worse. Withdrawing $540 billion of liquidity in mid January would thus cause the mother of all liquidity squeezes and is probably impossible. It is thus likely that the ECB and other central banks will have to roll over most of the $540 billion for an additional period; essentially they will have locked themselves in. As with Northern Rock, taxpayers will be on the hook, only this time for $540 billion.
The extent to which this leads to actual losses depends primarily on the decline in US house prices, that in British house prices, and whether tighter credit conditions lead to a general decline in real estate values worldwide. The central banks of the world will certainly make every effort to avoid such an outcome, if only because with $660 billion at stake (including Northern Rock and its guarantees) they are now locked into the long term health of the real estate market.
While the loss of $660 billion in taxpayers’ money in itself is of only moderate salience to them, central bankers who lost such sums would be subject to endless ignorant interrogation, not by the media which they are used to, but by the parliamentary and congressional committees to which they are nominally responsible. (Presumably the ECB bankers could in extremis appeal to the European Court of Human Rights, on the grounds that subjecting them to a series of lengthy grillings on a complex technical subject by a committee of Euro-MPs was contrary to EU human rights law.)
There is only one way in which central bankers can minimize the losses on $660 billion of what is effectively real estate related debt: they must cause a high level of inflation. Ordinary inflation of 5-6% won’t do, because it will not sufficiently change investor psychology. To achieve their objective of sustaining real estate, central bankers must induce a state of inflationary panic, causing inflation to be high enough that investors flood into real assets, of which the most conspicuous is real estate. This will prop up the nominal prices of the assets and, by reducing the real value of the associated debt, sustain the mortgage transactions which underlie the dodgy SIVs which underlie the tottering banks whose paper the central banks are now holding. Of course, the real value of the central banks’ $660 billion in short term loans and guarantees will decline, but since that decline does not have to be reflected in the accounts, nobody will care. After all, if central banks run out of money, they can just print some more.
The ECB has in the past been fairly sound on preventing inflation, as befits its partly Bundesbank ancestry, but as can be seen from its current rate of M2 growth, it has become much sloppier since the French graduate of the Ecole Nationale d’Administration Jean-Claude Trichet took over from Wim Duisenberg in November 2003. Eurozone M2 money growth was 8.5% in 2005 and 9.3% in 2006, rising to 11.2% in the year to October 2007.
All three figures are far above the 5-6% annual increase in Eurozone Gross Domestic Product, indicating that under Trichet European monetary policy has strayed far from its German roots and become thoroughly inflationary. While a rapid increase in money creation by the Fed runs the risk of a collapse in the value of the dollar, because of past profligacies, no such danger confronts the ECB – excessive monetary creation in euros, while it will cause inflation to accelerate worldwide, will domestically mostly serve to dampen the undesirable rise in the value of the euro against the dollar.
So there you have it – a monetary forecast for 2008. Central banks are now committed to maintaining as far as possible the value of real estate, particularly housing in the United States and Britain, where it is showing signs of collapsing. They will thus inflate the money supply, causing retail price inflation and further commodity and energy price inflation but slowing the decline in house prices and improving the value of their locked-in holdings of bank paper and guarantees.
However, because a money supply increase by the Fed might destroy confidence in the dollar, which would force a tightening in monetary policy and prevent achievement of the central bankers’ primary objective, the loosest monetary policy will come from the ECB, with the additional money created being transmitted to the US and Britain through the mechanism of the foreign exchange markets and both countries’ payments deficits.
Inflation in the Euro zone will remain modest, in spite of the rapid money creation, because the euro’s appreciation will reduce the price of imports to Eurozone consumers. For them, the rise in commodity and energy prices will be dampened while the prices of manufactured goods from Asia will steadily grow more competitive in the Eurozone as the euro rises against Asian currencies.
Inflation will appear in the United States, in Britain, where the pound will decline against the euro but probably remain quite strong against the dollar and in India and China, whose fairly primitive monetary systems will not be able to resist the tsunami of “hot money” investment from speculators and hedge funds.
By December 2008, US and British consumer price inflation will be approaching 10% per annum, and it will be well above that level in both India and China. However there will have been no outright recession, or only a mild one. Moreover, the decline in real estate values will have been slow, and in the US will appear to be turning around (but not in Britain where London house prices, currently far more inflated than in the US, will be adversely affected by the decline in the City of London’s revenues.)
Once again, central banks will have achieved a barely acceptable short term resolution to a crisis – at the cost of a lengthy and painful long-term recession, as interest rates finally have to be raised to combat a double-digit inflation that will seem to have appeared from nowhere and embedded itself unexpectedly deeply in the economies of Britain and the United States.
That however will be a problem for the new US administration that takes office in January 2009. Trichet will still be around (his term of office extends to November 2011) but the main political headaches of reversing his excessive money creation will occur in the US and Britain, neither of them under his jurisdiction. If Trichet is clever, he will move the ECB to slower money creation once US and British real estate prices have stabilized. That will allow Eurozone interest rates to rise moderately, while remaining lower than the crisis rates in the Anglosphere. Then he will be able to contrast the problems in the US and Britain with the favorable outlook for Euro zone inflation under his Presidency of the ECB.
For a French intellectual, particularly an ENArque, proving such superiority to the Anglosphere is always the most satisfying outcome of all!