In this video, posted for Radio Free Wall Street subscribers on June 13, 2014, Lee Adler shows why the ECBs new policy is a ridiculous con that won’t work to solve Europe’s economic problems. He also reviewed the data (as of June 13, 2014) that suggests US stocks were still likely to make more new highs.
The balance between QE and Treasury supply will begin to shift in July. The underlying bid it has provided for stocks and Treasuries will begin to fade.
This report tells why, and what to look for in the data and the markets. GO TO THE POST
On June 6, , the ECB announced that it would begin to charge interest at the rate of 10 basis points on deposits held at the central bank. The institution of the negative deposit rate has resulted in the universal misconception that this is supposed to spur banks to lend more to business by discouraging them from holding deposits at the central bank, as if this were somehow even possible, which it is not.
Deposits are created when the loans are made. That applies not only to central banks, but banks in general. Banks do not need central bank money to create loans. Banks can create loans, and money—deposits—out of thin air, subject to reserve requirements, which today are effectively zero. Loans create deposits. Deposits create reserves.
What happens when a central bank lends money to banks? It creates a deposit in the bank’s account at the central bank. On the one hand the loan becomes an asset of the central bank. On the other hand, the deposit that is created becomes a liability of the central bank. The two amounts are equal.
The immutable law of accounting, on any balance sheet, is that assets equal liabilities plus capital. In the case of the central bank, capital is essentially a fixed amount, therefore any increase in assets will result in an equal increase in liabilities when the central bank makes a loan to a bank. Conversely, when a bank repays a loan, the deposit is extinguished and money disappears.
A portion of the banking system’s balance sheet is therefore the mirror image of the central bank’s balance sheet. The banking system’s cash assets acquired as a result of loans made by the central bank can not be “withdrawn” from the central bank to make loans, nor do they need to be. The only way the banking system could withdraw those deposits would be to literally ask for truckloads of paper cash to be delivered to their own vaults. Needless to say, that’s not likely to happen, short of bank runs by depositors demanding cash from them.
The amounts of money on deposit at the ECB are immutable. They can be shifted from one liability category to another, such as from accounts known as “Current Accounts” to Deposit facility or Fixed Term Deposits. The first two will now charge 10 basis points to the holder. The Fixed Term Deposits which the ECB offers regularly still pay a nominal interest rate. So there will be increased demand for those as banks try to reduce their costs. But other than withdrawing paper cash, the banks can only reduce their deposits at the ECB one way. That’s to pay back the loans that created the deposits.
With the ECB now charging interest on deposits, lo and behold this week, that’s exactly what happened. The balance sheet shrank by €25 billion in the week ended June 6. That’s exactly the opposite of the ECB’s intent, but entirely predictable. [Note: Since then, through July 10 the ECB’s balance sheet has shrunken by an additional €167 billion.
The ECB knew that that could happen, so simultaneously with charging 10 basis points interest on deposits it also reduced the interest rate on its weekly main refinancing operations (MRO) by 10 basis points. This results in an absolute wash in the banking system’s cost of funds over time as the new MROs at the lower rate replace outstanding MROs at the higher rate. [Note: The deposit became effective immediately on all existing deposits. The reduced loan cost applies only to new loans.]
The banking systems’ cost on funds obtained from the ECB equal the interest cost of the borrowed funds less any interest paid on the deposits created or plus any interest charged on deposits. The old loan interest rain was 25 basis points, and the resulting deposit at the central bank paid zero. The net cost to the banking system was 25 basis points. If the loan cost is reduced to 15 basis points and the deposit rate is increased to 10 basis points, the cost to the banking system is calculated
Interest on loan .15 + deposit cost -.10 = .25.
In other words, the cost of the funds equals the 15 basis points in interest on the loan plus the 10 basis points charge on the deposits for a total cost of funds of .25 basis points.
There’s no difference in the cost of the loans before and after. There’s no incentive to do anything, and in fact even if the cost were ten times as much it could not encourage banks to make more loans. Banks can create loans at will. They do not need central bank money to create loans. The issue is not the lack of willingness or ability of the banking system to make loans. The issue is the lack of qualified demand.
There are times when banks go insane and make loans to unqualified borrowers. We’ve just been through one of those periods. Chastened by the resulting collapse, most banks, in the interest of self preservation, have only been interested in making loans to qualified borrowers. What’s lacking today is qualified borrowers. Effective loan demand is weak, and there’s nothing the ECB can do about that.
The Fed knows that, so instead of voluntary lending programs, it resorts to outright securities purchases to inject funds into the system. While the ECB’s balance sheet keeps shrinking, the Fed, by forcing Primary Dealers to sell securities to it keeps growing its balance sheet and keeps forcing cash into the system. Since economic loan demand is far less than the amount of cash the Fed is forcing into the system, its actions only causes
The ECB can’t do that because it does not have a captive dealer system to force funds into the system. It also does not purchase government securities except on a limited and tortured basis to get around its own rules. To counter that problem it is now making plans to purchase asset backed securities. The ostensible purpose of that is to stimulate bank lending to businesses. But that can’t work without qualified borrowers for the banks to lend to. What it will do is further stimulate the worldwide asset bubble as the ECB buys more ABS than the banks can replace with new lending.
It would appear that the ECB is either stupid or insane if it believes these measures will work. But the ECB is neither stupid nor insane. These new policies are just a bluff, a con, an attempt to get the market to believe some kind of fantasy in the vain, stupid, and foolish hope that that will somehow stimulate the European economy. My guess is that it won’t work.
Charging interest on those deposits will not stimulate lending. There’s so much ignorance and misinformation being promulgated in the media and the blogging community about the ECB’s new program, it is stunning. Absolutely stunning. Apparently no journalists or bloggers understand the simplest basics of double entry accounting and the fact that there are two different balance sheets involved in central bank actions.
For each central bank action there is a debit and a credit on the books of the central bank, and a debit and a credit on the books of the banks. When a central bank lends to banks, that creates a cash asset on the banks’ ledger. Those assets are held as deposits at the central bank (or they can ask for and get vault cash- but they don’t because there’s insufficient demand for paper cash). Central banks can’t direct what banks do with the cash assets created on the banks’ balance sheet when the central bank makes a loan to them. The fact of whether it is paying interest on the deposits so created, or charging interest on them has zero impact on total money supply. There’s no sterilization.
Furthermore, unlike the Fed’s purchases from Primary Dealers, the ECB’s programs are voluntary. It cannot force banks to borrow money. OK, with the LTRO it “strongly encouraged” all banks to borrow the funds, look what happened when the involuntary holding period ended. Those funds were repaid lickety split. Some of the unneeded funds were clearly used to fund a US Treasury carry trade. As soon as the banks were allowed to begin repaying the LTRO after the mandatory one year holding period, look what happened. The Fed has had a voluntary lending program forever. It’s called the Discount Window. Nobody uses it.
Any strictly voluntary lending programs that are restricted to a specific purpose where there’s no profit incentive and no qualified borrowers for the banks to actually lend to, won’t be used.
The interest that the ECB will now charge on deposits is a direct offset to the reduced cost on the loans it has outstanding to the banks. It’s a wash transaction. Will the banks voluntarily increase lending because of that? Obviously not. Furthermore, you need qualified borrowers. You cannot force banks to lend money they know or strongly believe can’t be repaid.
It’s all a con, a shell game. And the nonsense about it in the media is truly frightening.
Banks do not need central bank cash to create loans. A loan creates its own cash and own reserve at the bank. With all the excess cash already on their books, the only constraints on lending is demand from qualified borrowers and bank capital. If capital/asset ratios are adequate banks can lend. Whether they will or not depends on qualified loan demand.
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