Squeak and Awe

May 3, 2013

MICHAEL WRIGHT: What's this about the European Central Bank charging a negative interest rate on bank deposits?

PUNDITA: Squeak and Awe.

MICHAEL: [laughing] Squeak and Awe?

PUNDITA: That was the snap analysis from a British reporter for CNBC. God bless British wit. It turned out he nailed it; the next day someone from the European Central Bank said that the talk about a negative interest rate at the Bratislava conference was just tossing around ideas, thinking aloud.

MICHAEL: Thinking aloud in front of a public microphone. The euro fell against the dollar on [ECB President Mario Draghi's] talk about a negative interest rate.

PUNDITA: It rebounded once currency traders deciphered Draghi's statements.

MICHAEL: What was his point? Was it a shot across the Federal Reserve's bow? Are we looking at a currency war?

PUNDITA: There are two different types of interest rates in play here. The ECB did make another cut in the interest it charges banks to borrow money from it. Maybe this cut was in part a reaction to the Fed's continued quantitative easing. But Draghi's talk about a negative interest rate relates to the interest the European Union's central bank pays to Eurozone banks that stash a big chunk of their money at the ECB. The interest the ECB currently pays is already at zero percent.

The zero rate is due to pressure on the central bank from Eurozone governments. They don't want the ECB encouraging Eurozone banks to sit on mountains of money; they want them lending the money to businesses to help kickstart the Eurozone economies. This is on the theory that with rapid business expansion will come rapid hiring of many people. This on the theory that with more people employed they'll spend more on making purchases, which will fatten the starving revenues from the Value Added Tax.

MICHAEL: I know there's high unemployment across the Eurozone.

PUNDITA: Yes. It's about 17 percent, and in some Eurozone nations it's much higher than the overall figure. If I recall the unemployment rate in Spain is around 50 percent. So the governments want these unemployed people off the dole and into stores to buy stuff.

All this depends on making the banking system the tip of the spear in EU recession-era fiscal policy. The position of Europe's bankers is, 'Hey! We're not employment agencies.' So their response to the zero interest rate has been to stick their fingers in their ears and chant, 'Lalalalalala we're not listening.'

Draghi's rumination in front of an open mike about a negative interest rate, which works out to a penalty fee, was his way of saying 'Read my lips.'

To show how shocked and awed Europe's bankers were by the threat, another idea to come from the Bratislava confab is that the ECB will directly extend credit to small and medium-size businesses. This is an acknowledgment that if a zero interest rate doesn't scare bankers into putting on a suicide vest, a penalty fee on top of that isn't going to turn them into martyrs either.

However, there are actually a few teeth in Draghi's Squeak and Awe moment. The ECB is saying to the bankers, 'If you won't lend to the little guy, we'll lend out the money you stashed with us. This means we'll collect the interest on the loans, not you. On top of this we just might charge you a fee for lending out your stash.'

MICHAEL: Where are the teeth in this?

PUNDITA: The implication is if the European Union's central bank has to act like a neighborhood lender, what does it need neighborhood banks for? The real threat is always the unspoken one.

MICHAEL: What's the real threat? That they'll nationalize all the banks?

PUNDITA: Many of Europe's banks are already nationalized, or at least partly supported by taxpayers. But these nationalizations are local to each sovereign government in the Eurozone. The real threat, the unspoken one, is that the banking system of each Eurozone country will be put under the control of the European Parliament, with the monetary policy for the entire Eurozone controlled by just one central bank -- the ECB.

MICHAEL: Rahm Emanuel's dictum. Never let a crisis go to waste. Is the fear that they're using the banking system as a backdoor way to force Eurozone nations into a United States of Europe?

PUNDITA: Well if there are sovereign governments that're afraid of this, it's a little late in the day for the fear to manifest. If the friendly neighborhood heroin dealer is handing out free samples, people should realize this isn't going to work out to their benefit. In the same manner, the GIPS governments got into the habit of turning to the ECB for cheap loans after they spent themselves into an impossible load of debt. So they should have seen the Cyprus solution coming a mile away. The solution being that when a government claims it has no collateral whatsoever to put up for another loan, the ECB asks, 'What about the pension funds?'

However, that's the view of EU Skeptics and those who believe in Them. Them being a SMERSH-like organization of fabulously wealthy evil geniuses who're plotting to take over the world. The other side of the story is Benjamin Franklin's advice to American revolutionaries during the war against the British crown: If we don't hang together we'll surely hang separately. Even many Europeans who hate the ECB and the EU Commission support a united Europe on that very same argument. It's just that forging sovereign nations into a single nation is a messy and unpleasant process -- one that can crash governments and lead to much violence.

MICHAEL: I'm with the bankers on this one. European business can't expand into weak consumer demand. It's the same problem we have in the U.S.

PUNDITA: Apple computer's bond offering is to buy up more of their stock, supposedly ahead of returning a big chunk of the cash they're sitting on to their shareholders. That's great for shareholders and especially for funds that have a large position in Apple shares. But this is Apple's way of saying that they're not going to throw their mountain of cash into business expansion because there's not enough consumer demand to expand into, not anywhere on the horizon. Same problem in Europe. Same in China. Same everywhere. And what consumer demand exists is in exports, which run into the stiff headwind of protectionism and the locals doing their own versions of the imported good and services.

MICHAEL: Isn't the Federal Reserve's quantitative easing supposed to solve the problems of slow business growth and weak consumer demand?

PUNDITA: No. It's to export U.S. debt and flush scared money out of bank deposits and into the investment markets and from there into purchases of big-ticket consumer goods and houses. QE is an effort to appease the Ghost of 1929.

MICHAEL: It looks to me as if all it's done is set up currency wars between central banks. Every major central bank is slashing the interest it charges to lend to its banks. What's this doing, besides cheapening every nation's currency? QE isn't encouraging business expansion. It's not putting people back to work. The better than expected [U.S.] job figures released today are a joke when you drill down into the numbers. The spike in the stock market today was just relief that the unemployment figure was not as bad as everyone feared.

All I'm seeing is, you cut your interest rate by so many points, I'll cut mine. Where's this leading? You talk about the Ghost of 1929. Maybe governments are so focused on the ghost they're not seeing the Ghost of 1939 gaining on them.

PUNDITA: Well, I don't think we have immediate worries on that score, not unless Europe and Asia can materialize big blue water navies out of thin air. The problem with doing this is that a big blue water navy costs big money, and it so happens that quantitative easing is meant to flood the banking system with cheap money, not the 'real' economy -- the one that builds blue water navies.

If you want to build a real ship you have to do it with real raw materials that are mined and shipped by companies which have employees who can't pay their bills with quantitative easing. They want to be paid in real money.

MICHAEL: The companies also want to be paid in real money. They aren't going to take on big debt to build those ships; not on the deal that if they build the ships government promises to raise enough in taxes during a recession to buy them.

PUNDITA: Right! [laughing] There's a certain circularity in this situation. The Federal Reserve doesn't actually print money to finance government debt. It creates money -- actually, "near money" -- when it buys government bonds. It does this when the amount of the purchase is recorded in electronic ciphers. Bing! So many more millions of dollars appear on the computer screen.

The Fed does the same thing every time it lends to banks within the Fed's banking system. Same happens when the banks lend money to each other to keep their rate of lending in line with fractional reserve banking regulations. Each loan and repayment creates more near money, which expands the money supply within the banking system. But at the very end of this process of near money creation is a person who can't take the Federal Reserve with him every time he wants to buy school clothes for his kids.

MICHAEL: The individual is expected to act like a government only up until the point where he can't pay his bills.

PUNDITA: That's it. He can't take the pile of school clothes to the checkout counter at Target and tell the clerk, 'Let's do our part to prevent another Great Depression. I don't have the money to pay you. But for the sake of liquidity, you take my handshake as assurance that if you simply ring up the amount of this merchandise and I walk out of the store with it, you'll be keeping the velocity of money going.'

MICHAEL: The clerk will call for the security guards. But nobody's going to put the Fed in jail for shoplifting.

PUNDITA: Yes, well, it's not considered shoplifting when governments and a nation's central banks do it. Any rate, I don't see another world war looming. Right now the Ghost of 1929 rules -- fear of the ghost.

The Ghost

As to a currency war, maybe the ECB's latest bout of QE was partly in reaction to the Fed's May Day announcement that their cheap cost of lending to US banks will get even cheaper or maybe it will get expensive, circumstances warranting.

Now what would these circumstances be? In March, Ben Bernanke pulled a magic number of the air: QE would ease up if the U.S. unemployment number fell below 6.5 percent -- or 6.6 percent; I don't recall -- and stayed below that number for a few months. On May Day -- two days before the latest jobs number was released to the public -- the wording of the announcement was a little different. It boiled down to saying that QE will increase or decrease depending on circumstances that only The Shadow knows.

So until The Shadow speaks, the Fed will continue to pump 85 billion dollars every month into the U.S. banking system. And if other central banks have to keep up by continuing to slash the interest they charge to lend to their own banks, that's their problem. India's central bank is already complaining that it's cut the lending rate so many times it's running out of room to cut.

MICHAEL: This is insanity.

PUNDITA: It's antiquated monetary and economic theories running headlong into the era of mega populations, mega global trade, and floating currency exchange rates. A standard economic theory is that it's possible for a nation to export its way out of a recession. On paper that works, but only when it's just one country or one small world region that's creating the flood of exports and driving down the cost of its currency to make its exports very attractive to foreign buyers. The theory falls apart when currencies float against each other in worth, as they have since 1973, and when much of the world is trying to export its way out of recession, as it is now.

The upshot is not so much a currency war as a chain reaction.

MICHAEL: If they can see this, if they know these old policies don't work today, why do they keep using them?

PUNDITA: Why did high priests keep throwing virgins off a cliff when it was obvious that this was no longer producing a bumper harvest? I once wrote an essay for my blog on this topic. The answer is, 'How do you know that if you stop throwing virgins off a cliff, this won't make the weather gods even angrier?'

Same argument applies when it comes to defending fiscal and monetary policies that were originally designed to ward off a replay of the Great Depression. Have we had another collapse of the banking system since the 1930s? No. If you tell them, 'Yeah but we had a collapse of the shadow banking system in 2007,' they'll tell you, 'That's not the banking system.'

You can't get there from here, Michael. The road is littered with sacred cows -- talismans to ward off the Ghost of 1929.

MICHAEL: Okay, so what are we waiting for? A modern day version of the Conquistadors? A gang of trillionaires with AR-15s to come along and say it's nuts to throw virgins off cliffs?

PUNDITA: [laughing] Listen, I got up at 4 in the morning to watch the news from Europe. I need chocolate and caffeine.

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