Opinion

ECB's multibillion lending missing the mark

03.11.08 @ 09:21

  1. By George Irvin

At the end of October 2008, the European Central Bank's (ECB) lending to the banking sector reached the €750 billion mark.

  • The current financial shock is many orders of magnitude greater than the oil shocks of two generations ago (Photo: EUobserver)

That's a lot of money - over a trillion US dollars - and we are assured by Frankfurt that every cent of it is needed to get the banks lending to each other again. The problem is that flooding the market with liquidity won't work, unless accompanied by an immediate and deep cut in the ECB's lending rate. Why?

The ECB benchmark interest rate is 3.75 percent, and it may come down by 25-50 basis points next week.

That's lower than the Bank of England (BoE) at 4.5 percent but considerably above the Fed's rate of 1 percent. David Blanchflower of the BoE's Monetary Policy Committee has been highly critical of his fellow committee members for keeping the interest rate too high for too long.

According to Mr Blanchflower, the BoE's obsession with inflation has blinded it to the realities of recession and the need to cut borrowing costs drastically. In consequence, Britain has entered a serious recession which may last 18 months or more. Exactly the same criticism can be made of the ECB.

The only difference is that no economist in Frankfurt has dared to challenge current orthodoxy.

Real economy

We are entering a phase where the financial crisis is affecting the real economy - not just in the US and Europe but in the whole world.

What started a year ago as a "sub-prime crisis" has turned first into a credit crunch, then into a threatened collapse of the world's major banks and it is now destabilising world stock markets, playing havoc with currencies and squeezing economic production, jobs and spending power around the globe.

Volatile capital and forex markets are pushing whole countries into the hands of the International Monetary Fund (IMF): first Iceland, then Ukraine and now Hungary. Belarus and Pakistan are next in line.

Nor has the IMF changed its standard recipe for economic recovery: programmes with the IMF are conditional on governments cutting expenditure and maintaining high real interest rates to safeguard their currency. Just as with the Asian crisis of 1997, the IMF has prioritised maintaining the value of the currency in order to ensure that debtor countries don't default on foreign loans.

These foreign loans - including in Hungary's case euro-denominated mortgages - are being repaid to EU banks by axing jobs and social services.

And just as the Koreans were made to sell Daewoo at a knockdown price to General Motors, so a firesale will doubtless follow in these countries too. Nor is it only small countries that are vulnerable; already there are capital and currency market troubles brewing in Russia, Brazil, Korea and Australia. The world is being sucked into the whirlwind.

Why is the crisis so deep?

Not only is the crisis world-wide, it's structurally deep as well. For years, lightly regulated banks and other financial institutions have been leveraging their positions in order to increase profits, i.e. using borrowed money to supplement their own equity. Everywhere from private equity buyout firms to hedge funds, "leverage" became the buzzword of the decade.

The financial market is huge: its growth since 1980 is unprecedented. The value of financial assets - bank assets, equities, private and public securities - increased from $12 trillion in 1980 to an estimated $160 trillion in 2007. Because hedge funds and investment banks now provide such a large proportion of market liquidity, credit contraction will be far worse than in previous downturns.

Think of a leveraged financial system as an inverted pyramid - the more it grows, the more unstable it becomes.

The suspicion that some of the debt will not be paid causes one bit of the pyramid to crumble, and failure in one part of the system soon spreads to the rest. Borrowing becomes more expensive. As financial institutions "deleverage," the contractionary impact on the economy is enormous.

Those of us who can remember the 1970s recall that the "oil shocks" took demand from the economy and brought growth to a halt. The current financial shock is many orders of magnitude greater than the oil shocks of two generations ago.

Recapitalising the banks is not enough

In the past months, the world's main central banks have put together huge bailout packages. In essence, they have propped up the financial houses' balance sheets in the hope that this would get them lending again, not just to each other but to the rest of the economy.

The problem is that such bailouts do not necessarily restore the status quo ante. Banks can hold on to their cash, and indeed are likely to do so unless borrowing costs fall and investors' confidence picks up.

To stimulate borrowing, a strong signal is needed. Central banks must cut their benchmark rates close to zero. This became clear in the UK several months ago when, despite a small cut by the Bank of England, LIBOR (the rate at which commercial banks lend to each other) actually rose, as indeed has its euro equivalent, EURIBOR.

Corporate bond yields have also risen, i.e. corporate borrowing has become more expensive. Even as I write this piece at the end of October, yields on non-investment grade bonds in the UK have climbed 35 basis points to a new high of 21.79 percent. And across Europe, yields have jumped 51 basis points to a fresh record of 23.35 percent.

As Graham Turner of GFC Economics has noted, recapitalising the banks has not stopped the rise in corporate bond yields simply because government has not eased monetary policy sufficiently to mitigate the risk of large-scale defaults.

Of course it is difficult to halt some of this great unwinding; some deleveraging was inevitable. But cutting interest rates early and sharply could certainly have cushioned the fallout, perhaps to the point where markets were confident that the risks of recession were contained.

The way things stand at present, we have the worst of both worlds. Enormous sums have been poured into bailing out the banks, but we have not averted recession. As always, it is the poor and the insecure who feel the greatest pain in a recession; those whose houses are repossessed, whose job on a construction site or at the local supermarket disappears. It is not the banker eased into early retirement by a bonus of several million euros.

Deleveraging has been allowed to gather such momentum that even the most extreme monetary easing - zero nominal interest rates - will be required. Moreover, such monetary easing will be absolutely necessary if reflationary fiscal policy is to work. In Japan in the early 1990s, it was the failure to cut borrowing costs quickly enough which sapped investor and consumer confidence and rendered fiscal policy largely ineffective.

Mr Bernanke has pondered this lesson with some care, which is the reason why the US recession will probably not turn into a depression.

In the EU, however, Monsieur Trichet shows no sign of having given the matter any thought at all. Make no mistake! It is we Europeans who will pay the price for the intellectual poverty of our economic governance.

George Irvin is Research Professor of Economics at the University of London, SOAS, and author of "Super Rich: the growth of inequality in Britain and the United States" (Polity: 2007)

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