Central Bank Economy Lyn Alden Monetary Policy

The European Central Bank is Trapped. Here’s Why.

The credit-based global financial system we have constructed and participated in over the past century has to continually grow or die.

By Lyn Alden / LynAlden.com

Several of the major central banks are stuck in a trap of their own making.

This includes the US Federal Reserve, the Bank of Japan, the European Central Bank, and others.

The credit-based global financial system we have constructed and participated in over the past century has to continually grow or die. It’s like a game of musical chairs that we have to keep adding people and chairs to in order for it to never stop.

This is because cumulative debts are far larger than the total currency supply, meaning there are more claims for currency than there is currency. As such, too many of those claims can never be allowed to be called in at once; the party must always go on. When debt is too big relative to currency and starts to get called in, new currency is created, since it costs nothing other than some keystrokes to produce.

It’s like this for most major countries:

Debt vs Money

Chart Source: St. Louis Fed

In other words, claims for dollars (debt) grows far more quickly than the economy’s ability to generate dollars, and is far larger than the amount of dollars in existence. When this becomes too much of a problem, the amount of base money is simply increased by the central bank.

Base money is a liability of the central bank, and it’s used as a reserve asset by commercial banks. Broad money is the liability of commercial banks, and it’s used as a savings asset by the public. Treasuries are liabilities of the federal government, and they’re used as collateral by the central bank and commercial banks.

In other words, liabilities are collateralized by other liabilities, all the way down.

Further reading on this:

Central banks place guardrails on either side of that credit growth, trying (and often failing) to ensure that it doesn’t grow too quickly into a bubble or falter into a deflationary spiral of defaults. They want smooth credit growth with perhaps some mild cycles along the way, and smooth 2% average annual currency devaluation.

For decades, whenever economic growth was sluggish, central banks would reduce interest rates and encourage more credit growth (a.k.a. debt accumulation) which leads to spurts of economic growth. Whenever the economy was booming, they would increase interest rates and discourage credit growth, to try to cool things off.

The problem is that this level of micromanagement, with an understanding that the core system would always be bailed out if need be, contributed to higher and higher debt levels relative to GDP, both in private and public realms, and lower and lower interest rates.

During the past four decades, the increase in debt over time was always offset by reductions in interest rates, so that the cost of servicing that debt never really went up.

Eventually, however, major central banks all reached zero or even slightly negative interest rates, and there wasn’t realistically any lower to go. Any further debt increases at that point would be hard to offset by lower interest rates. The cost of serving the debt relative to GDP and incomes would actually start to rise.

In addition, if the world ever did run into a significant setback in productivity, such as through de-globalization or underinvestment in commodities which we are seeing now, then the resulting inflation would be hard to offset with increases in interest rates.

Interest Rates vs Inflation

Chart Source: YCharts

We haven’t seen this level of disconnect between inflation and interest rates since the 1940s, which is the last time that sovereign debt as a percentage of GDP in the developed world was as high as it is now.

So, much like the 1940s, many developed market central banks are trapped. They can’t raise interest rates persistently higher than the prevailing inflation rate, and instead are stuck with slowly moving interest rates up, jawboning forward guidance, yield curve control, and trying to inflate some of the debt away.

However, the European Central Bank arguably has the hardest job of all.

This was very apparent in the head of the ECB Christine Lagarde’s recent interview.

She was asked, “how will you get the balance sheet down?” while being shown the ECB balance sheet on a screen.

ECB Balance Sheet

Chart Source: Trading Economics

She answered, “It will come. It will come. In due course, it will come.”

The interviewer paused, confused, and then asked, “…how?”

And she answered, “In due course, it will come.” And then smiled.

She offered no answer, no description, no clarification, and had rather awkward expressions throughout the exchange.

This is because, like most central banks, there is no plan. It won’t come. Sovereign debt will be monetized to whatever extent it needs to be, or it’ll collapse. And for the ECB it is particularly tough, because they have to monetize debts of specific countries more-so than other countries.

A Monetary Union Without a Fiscal Union

Countries in the Euro Area have given up monetary sovereignty. Instead of maintaining their own currencies, they have agreed to use a shared currency, and thus a shared central bank.

This came with pros and cons, but due to the way it was structured, it has been politically unstable from the beginning.

The United States can unilaterally print dollars. Japan can unilaterally print yen. Their governments can heavily influence their central banks as needed. But Italy, for example, cannot unilaterally print euros or heavily influence the ECB on its own.

At first glance, this doesn’t seem so different than US states. Texas, California, New York, and other states can’t print dollars. So what’s the big deal if Euro Area countries can’t either?

Well, the difference is that the US mostly has a shared fiscal union in addition to a shared monetary union, whereas Europe mostly does not have a shared fiscal union.

US states share most of the same retirement, entitlement, and defense systems. Residents of all states pay into Medicare and Social Security, as well as the US Armed Forces, which collectively constitute the vast majority of federal government spending. Citizens of the US are not citizens of any specific state; they can move freely around the country under what is mostly the same entitlement system. In contrast, these entitlement systems very much differ between European countries.

At the end of the day, it’s the debt difference due to this lack of fiscal union that matters. European countries had higher debt levels when they became a monetary union, and they’ve only gone up since then.

Here are the top five US states by GDP, in terms of their state debt as a percentage of state GDP.

  • California: 5%
  • Texas: 3%
  • New York: 8%
  • Florida: 3%
  • Illinois: 7%

And here are the top five European countries by GDP, in terms of their national debt as a percentage of their national GDP:

  • Germany: 70%
  • France: 113%
  • Italy: 151%
  • Spain: 118%
  • Netherlands: 52%

The percentages of both US states and European countries can be increased further if we account for off-balance-sheet entitlement liabilities expected to occur in the future. These are basically debts that haven’t been marked to market yet. We can also include local debts in both calculations.

But regardless of how we calculate it, there’s a gaping difference in debt levels of US states and debt levels of European countries. In the US, public debt is mainly at the federal level rather than the state level, whereas in Europe, public debt is mainly held at the individual country level, and they don’t have individual central banks with unilateral base money creation ability.

In addition, commercial banks in Europe hold individual sovereign debt as a key part of their collateral. Meanwhile, commercial banks in New York, for example, don’t hold New York state debt as a key part of their collateral. They use Treasuries as their key collateral.

This shows how the situation is hardly comparable on this point. Most US states do not need debt monetization by the Fed to remain solvent. At some point, some of them may run into pension insolvencies, but that’s a not quite as structural of an issue. Several European countries, however, do need persistent debt monetization by the European Central Bank to remain solvent year-by-year. And by extension, that spreads out to the whole commercial banking sector.

To be clear, the US has a host of problems. I’ve written numerous articles about how the petrodollar system has undermined US manufacturing more-so than the rest of the developed world, for example. Unlike Europe, the US has run a structural trade deficit for decades and has a deeply negative net international investment position. The US is also more financialized than Europe in the sense that our stock market is big enough to affect our economy rather than just the other way around. We’re so consumption-oriented, stock-oriented, and reliant on the foreign sector recycling our trade deficits into our capital markets, that the “tail can actually wag the dog” in this sense.

But in terms of the specific ability to cease sovereign debt monetization for periods of time, that’s where the ECB is near the bottom of the pack compared to other central banks. It’s a more complicated political issue.

Robin Brooks, the chief economist at the Institute of International Finance, and the former chief FX strategist at Goldman Sachs and a former senior economist at the IMF, has some of the best charts to illustrate this issue. The solvency of Italy’s sovereign debt is in the hands of an entity, the ECB, that Italy has no unilateral control over:

ECB Italian Debt Monetization

Source: @RobinBrooksIIF

In the long run, I can’t imagine being a European investor and having sizable long-term exposure to the currency, especially within some of the southern European jurisdictions.

I’d much rather want to have real estate, profitable equities, commodities, gold, and bitcoin, than euros and euro-bonds. The same is true for the US, Japan, and other countries, but with Europe the currency comes with added tail risks, especially now that their energy security is seriously being put to the test.

Euro vs Gold

Chart Source: YCharts

Lyn Alden
Lyn Alden

Lyn Alden is the founder of Lyn Alden Investment Strategy, where she provides financial research to retail and institutional investors. With a background that blends engineering and finance, Lyn focuses on fundamental investing with a global macro overlay, and covers a broad array of asset classes including equities, currencies, commodities, and digital assets. 

13 comments

  1. Problems multiply like rabbits for a debtor nation when government monetizes the debt incurred from spending on welfare and war as though there were no tomorrow.

  2. > I’d much rather want to have real estate, profitable equities, commodities, gold, and **bitcoin**

    Yes, sure.

  3. I don’t think “we” have created this system. Elites have created it to maintain their power. It has nothing to do with the person on the street.

    1. I totally agree but given the state of the population at present, I would add that they would not be capable of imagining let alone instituting anything better. We are totally screwed.

  4. In order to now achieve real economic growth, debt-free market based medium must enter circulation, something that cannot be driven from the top-down but must be initiated by consumers as an organic process.

    The humungous debt bubble cannot be permitted to POP. It has to undergo a safe and sane leak as the economic growth takes place.

  5. David Graeber and Michael Hudson have documented how private debt has always built up until it de-stabilizes economies and empires for basically the entire length of human civilization. This happens no matter whether it is the palace/government or like now the private banks creating our money. This paradigm of Debt Only as the sole form amd vehicle for the creation and distribution of money is thus way over due for changing. All of the leading reforms like MMT, UBI and Ellen Brown’s Public Banking dance around and align with the new monetary and financial paradigm that needs to be integrated into the Debt Only based system. What is MMT? It’s monetary gifting to government contractors. UBI? Monetary gifting to the individual. Public Banking? In a fiat monetary system like we have a true publicly administered banking system would be able to lend at a rate of 0% thus gifting the sometimes double amount of the retail cost to consumers of big ticket items. The one policy no one has cognited on and is the very expression of the new monetary paradigm (Direct and Reciprocal Monetary Gifting) is a 50% Discount/Rebate policy at retail sale. This single policy woulf effect a paradigm change in the money system and economy. Why? Well a 50% discount at retail sale for virtually everything would immediately macro-economically eliminate any possibility of inflation…by (amazingly and mind blowingly for orthodox economic theorists) implementing BENEFICIAL price and asset deflation into profit making economic systems. It would also immediately double everyone’s purchasing power (you could buy $100 worth of goods or services for only $50) and potentially double the available demand for every enterprises goods and service. Thus it would fulfill two of the signatures of historical paradigm changes (new paradigm concepts are always in conceptual opposition to the old paradigm (here it is Debt Only vs Monetary Gifting), and inversion of temporal universe reality (from erosive inflation to beneficial deflation).

    Here is my book on the subject: https://www.amazon.com/dp/B07PLNJLRN/ref=sr_1_1?keywords=wisdomics-Gracenomics&qid=1552358772&s=books&sr=1-1-catcorr

    1. Graeber and coauthor Wengrow of “The Dawn of Everything” supports Hudsons research on debt forgiveness, Jubilee, as necessary for society. What they don’t say is those debt jubilees were evident to the rulers of Sumeria, Babylon and Persia because their people could just up and leave and go live in the hills with their goats or in the marshland bayous with their boats. To keep people supporting the temples they had to stay on the land producing grain. By Ceasar’s, Gracci Brothers’ and Jesus’ time the possibility of abandoning the cities and farms and living independently was diminished. And all it took was one or two crop failures to point out that the ruler/priests who held the debt were not in communication with god. They had the choice of forgiving debt or having to do their own labor.
      I like your ideas but the banksters will not give up power. They will take down civilization rather than relinquish control of the 99%. They are pathological narcissists with no empathy or conscience. The lesson we have to teach the children is that when civilization is rebuilt to not allow privately held corporations especially banks.

      1. You’re correct that finance will not surrender their monopoly paradigm without a fight. But we must keep in mind the insight of Sun Tsu the great Japanese military strategist who observed that if you convince the enemy there is no hope in fighting you have won the war without a battle. We also need to heed Victor Hugo’s dictum that “Nothing is more powerful than an idea whose time has come.” That’s why a mass movement is necessary to communicate the benefiits of the new paradigm is necessary in order to herd the entirety of the political apparatus toward sanity and survival. That’s how Ghandi, MLK, Jr. etc. did it. And yes it must be broadcast continually that there are no enemies of the new monetary paradigm except those who own and control the present one.

        We have to be smarter than the ancients who utilized palliative occasional debt jubilee. Two of the other policies in my book are a $1000/mo. universal dividend for everyone 18 and older for life and a 25-50% debt jubilee at the point of loan signing. Reforms never last, but paradigm changes are forever.

    2. what is this other than nominal depreciation of fiat money? Since money is a commodity what would be the price of money? How do interest rates relate to that ‘discount’?

      1. You’ve missed the fact that a 50% discount at retail sale macro-economically implements price and asset DEFLATION into profit masking economic systems. Hence there would be no depreciation of the currency’s purchasing power. Economic theories on both the left and right simp[ly do not work anymore. The reason for this is the 6000 years old and counting monetary paradigm has never changed. Money DOES make the world go ’round, integrate the new monetary paradigm of Gifting strategically into the Debt Only based system and we will finally be able to enable it to accomplish the general Good. Change the monetary paradigm and change the world.

  6. Great Strategy to act like a real social democracy and overcome the lethargy of this dual-party Vichy-facade of faux-democracy:

    We Americans love to watch war movies and act like the most powerful country in the world — so why not enforce, enjoy, and endorse ‘power’, even the power of war.

    If ‘we the people of America’ want to live that dream, then we could enable their “We’re #1”, “We’re #1”, “We’re #1” power fantasy and harness it to something that will really help our weakened, wandering, and merely wishful fantasy into real political power?

    If, [big if], Bye Bye Byeden and an invigorated, and truly (small ‘d’) democracy party wanted to act decisively and powerfully over these damned ‘economic royalists’ of both the right and left ‘pro-Empire’ parties and this entire Disguised Global Crony Capitalist Racist Propagandist Criminal Ecocidal Child-Killing & War-Starting EMPIRE, controlled by the ‘Ruling-Elite’, UHNWI, <0.003%ers, TCCers, arrogantly self-appointed "Masters of the Universe", and "Evil (not-so) Geniuses" [Kurt Andersen] — which hides Empire behind their totally corrupted dual-party Vichy-facade of faux-democracy — all that 'we the people' have to do in a first revolutionary act is to lay-out the fact that we are essentially already at war, certainly an 'economic war' in supporting Ukraine to the tune of over $50 billions of dollars.

    Biden has the power to easily and popularly enact the Defense Authorization Act and order Exxon and other damn looting oil capitalist corporations to immediately increase gasoline refining supplies along with imposing wartime 'price controls'.

    Yes, I admit that using this winning Strategy might save the otherwise useless Democratic Party — but the 'forward playing' Strategy, even as close as 2024 lead to democratic socialism

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