Zombie Banks and Vampire Governments

The game of kick the can will continue

by Gary North

The term "zombie banks" refers to banks that refuse to lend to the private sector. They are run by fearful bankers who do not trust other bankers. They do not trust many potential borrowers. According to legend, zombies survive by eating the brains of their victims. It seems to me that zombie bankers must be limiting their diet to brains of other bankers and investment fund managers.

Governments are ready borrowers of money lent by zombie banks. Zombie bankers think that their banks' money is safer with sovereign nations' IOUs than with other forms of IOUs. The governments siphon off the money that could have been lent to the private sector.

Zombie bankers in Europe keep lending to PIIGS governments whose leaders promise reforms. Politicians promise to cut spending Real Soon Now. So, bankers lend them more money. PIIGS' sovereign debt interest rates then fall below panic mode, which is usually regarded as 7% or higher. When rates fall, investors then buy European stocks, because they believe that the financial problem in Greece is almost over, despite evidence to the contrary. All that investors care about is that government debt will be rolled over, somehow. This, European bankers are pleased to do for as long as they can borrow at 1% and lend at 6%. They love leverage.

The European Central Bank is providing the basis of this leverage. It is inflating the eurozone's money supply. It is loading up on IOUs from commercial banks in the eurozone. This is a subsidy to commercial banks. The ECB assumes that commercial bankers will lend at high rates if they can borrow at 1%. The ECB is subsidizing zombie banks and vampire governments. It is killing two birds with one stone: fiat money.

If it loaned money directly to PIIGS, this would only indirectly benefit zombie banks. The PIIGS would make interest payments on time. But, by lending to the banks, the ECB directly benefits banks. The leverage restores their profitability. Best of all from everyone's point of view, there is no legal showdown between the EU and the ECB. PIIGS governments continue to issue IOUs at a breakneck pace. There is a market for their IOUs because of the ECB. They can run up the bill with ease. The zombie banks are flush with digital cash.

THE ECB: "DIGITS R US"

Throughout 2011, the European Central Bank's officials made the expected assurances that they were not planning to inflate the money supply in order to buy PIIGS debt. In early January, the head of the ECB assured an audience of German lawmakers that "Monetary-policy responsibility cannot substitute for government irresponsibility." That message was for the rubes.

The naive believed it. On September 8, The Economist reported: "At the least, this new tone suggests that interest rates will not move up again this year, as had once been feared. Whether the ECB will swallow its pride and lower them soon, as some hope, seems unlikely."

In October, Mario Draghi replaced Jean-Claude Trichet.

Still, the faithful kept the faith. One of them wrote this in November.

Over the past week, we've heard all sorts of propositions that the European Central Bank (ECB) "must" begin printing money to bail out Italy and other countries, because "there is no other option." There are three basic difficulties with this idea. The first is that ECB buying might help to address immediate liquidity issues of distressed European countries, but it would not address long-term solvency issues, and would in fact make them worse. The second is that the ECB, under existing European treaties, has no such authority, and the prohibitions against it are very explicit. Changing that would be far more difficult than many market participants seem to believe, because it would require an explicit and unanimous change in the EU Treaties that AAA rated countries such as Germany and Finland vehemently oppose.

Notice the focus: the legal issue of whether the ECB could legally buy sovereign nations' debt under the European Union treaty. He concluded:

Investors are not likely to be treated with a "surprise" announcement that the ECB is going to expand its purchases of distressed European debt. Any significant ECB intervention would likely follow a formal revision of EU treaties that trades greater ECB flexibility in return for more centralized fiscal control.

In a "surprise announcement," the ECB lowered the rate from 1.5% to 1% on December 9. I would call this a surprise only for people who are easily surprised by the fact that central banks inflate whenever the value of large banks' portfolios of government bonds start falling because interest rates are rising.

The ECB's next surprise announcement came on February 29. It announced a new policy: lending over $700 billion in euros to banks at 1% for three years.

The unnamed analyst had focused on a very narrow issue, namely, whether the ECB would buy the IOUs issued by PIIGS. He offered legal reasons why it would not. This is a case of looking at the trees and ignoring the forest. He ignored the obvious: the ECB would lend to banks, which in turn would buy sovereign debt. It does not matter that there are zombie middleman involved. The ECB has increased the monetary base. The vampire governments are borrowing.

An analyst in the London Telegraph got it exactly right later on February 29.

ECB president, Mario Draghi, has effectively transformed the eurozone's toxic banks into zombie banks, addicted to his supply of cheap credit to keep them alive.

Across Europe hundreds of banks open their doors every day only because of Mr Draghi's intervention. These lenders may look like banks, call themselves banks, and, to their customers, feel like banks, but they are in reality wards of the ECB, going through the motions of banking.

These banks can make little impact on the real economy, and their main purpose in life is merely to survive and maintain the status-quo. They cannot afford to make loans and be the agents of Europe's economic recovery as they remain too bloated with toxic debt and are, to all intents and purposes, insolvent.

This latest round of monetary base expansion pushed the balance sheet of the ECB to over 3 trillion euros, which is $3.9 trillion. This is higher than the FED's $2.8 trillion.

PRICE INFLATION

The unnamed analyst offered an economic reason why the ECB would not inflate.

The third difficulty is that even if the ECB was to buy the debt of distressed European countries with printed money, the inflationary effects would likely be far more swift than anything we've seen in the United States. This would not "save" the euro, but would simply destroy it by other means.

We will now have an opportunity to test his theory. We will see if this will destroy the euro. So far, it has not.

To destroy the euro, the ECB's policy would have to be visibly more inflationary than the other major currencies. Cumberland Associates publishes a chart of the balance sheets of the four major central banks: FED, ECB, Bank of England, and Bank of Japan. They are all sharply higher since the summer of 2008, but the Bank of Japan is the most restrained. The ECB is the loosest.

None of the four nations is experiencing price inflation above 5%. So, to argue that the move by the ECB will "destroy it by other means" is to argue that mass monetary inflation will produce mass price inflation. I define "mass" as 15% to 25% per annum. Monetary base inflation has been in hyperinflation ranges in the USA, the eurozone, and Great Britain, yet price inflation has been modest. It is about 2% in the USA. It has been down slightly in Japan. The rate was above 5% in Great Britain in late 2008. It has fallen slightly since then to about 4.8%.

Commercial banks are not lending. They are building up excess reserves with their central banks. The fractional reserve process has ceased to function as it had prior to 2008. The money multiplier has fallen.

We are not seeing price inflation in the West. Yet the central banks are adding to their monetary bases. They have been able to do this because of central bankers' fear of lending. This has enabled central bankers to reap praise for their bailouts of large commercial banks. The large commercial banks have preserved the confidence of the depositors who count today: other bankers and fund managers.

The ECB will inflate the monetary base as surely as the Federal Reserve System will inflate. Whenever the interests of the largest banks are threatened by a recession, the central banks inflate. Whenever the largest banks stop lending to each other, due to fear they have regarding each other's solvency, the central banks inflate.

They believe that they can do this safely, because monetary inflation has not been translated into price inflation since 2008. Excess reserves reduce the fractional reserve multiplication. The public does not get upset. The politicians do not get upset. There are no negative sanctions.

The monetary base keeps rising, but interest rates are low. This means that the borrowing non-PIIGS governments do not face a sharp increase in cash outflow as a result of rising debt. The politicians are not sent a red ink alert by the Treasury. The solvent governments can easily make their interest payments.

The problem for PIIGS governments is severe. The higher that interest rates go, the larger the budget deficits. This pressures them to cut spending. They resist this. So, they borrow more. The governments have become vampires.

For as long as PIIGS governments can avoid a budget crisis, they will borrow. Whenever they do begin to face a budgetary crisis, the ECB inflates.

Politicians assume that the bills for this added debt will come due after they are out of office. They do not put on the brakes. They do not cut spending. They increase it.

This is kabuki theater. Politicians swear by everything they hold dearer than being re-elected that they will impose austerity. They will cut spending. Bankers then lend money at high rates because they can get all the money they want at 1%. The ECB provides the money.

The ECB offered no explanation for its actions on February 29. It issued no press release. No official gave a speech.

So, the expansion of the monetary bases of the central banks zooms into hyperinflation territory. The debt-to-GDP ratio of the governments goes above 100. Yet prices are stable and government bond rates are low. It looks as though this can go on indefinitely.

VAMPIRES SUCK

The governments absorb capital out of the economy. But this capital is of a peculiar nature. It is wealth that is being funded by the expansion of digits, not an increase in thrift. No one in the society is foregoing consumption. Central banks are providing the economies with digits, but commercial banks are either keeping this as excess reserves or else are lending to governments. If this newly created fiat money had been lent to businesses at low rates, the boom cycle would be visible. Capital would be allocated to the private sector, but only because lenders (bankers) believe that the recovery is real, meaning they will be repaid.

This would begin that Austrian theory of the business cycle. It is a misallocation of capital. It leads to a future bust.

Instead of another boom, we are seeing the transfer of wealth to governments, which keep issuing IOUs. The lenders of digits are providing the vampire borrowers the money necessary to bid resources away from the citizens who are not borrowing at low rates. The citizens who are not on the receiving end of government money are forced to cut back on their purchases of goods and services. Think of the unemployment rate for people 18 to 25 in Spain and Greece: over 40%. They are paying for the profligacy of their governments.

The system of central bank funding of governments, either directly (USA, Japan) or indirectly (eurozone), reallocates the flow of funds, and therefore the flow of wealth, toward governments and their dependents.

The wealth transfer involved in fiat money production – counterfeiting by the central banks – quietly undermines the private sector. The structure of production favors the holders of money. This money is not earned when central banks create digits called money. It is spent.

Vampire governments are like Draculas that fly into the night looking for victims. They extract wealth from the victims in a painless way. The victims sleep soundly, unaware that their life's blood is slowly being drained.

Like vampires of legends, this makes for more vampires. The allocation of wealth lowers people's real income. They are more likely to lose jobs and income. They are more likely to become dependent on the state.

The vampire state says "austerity will kill the recovery." Or "austerity will produce larger deficits." In the bust phase, government spending rises. In the boom phase, tax revenues rise, but spending keeps pace. The vampires still borrow. They still run deficits.

And so it goes, decade after decade. The vampire state gets more bloodthirsty, and the zombie bankers keep lending to them.

CONCLUSION

Fiat money is addictive. Zombie commercial banks use the funds provided by the ECB to buy IOUs from vampire states. The mainstream economists, who seem to have had their brains eaten, call for more spending by vampires and more accommodative injections of fiat money. The process does not reverse. It accelerates.

There will come a day when interest rates on non-PIIGS IOUs will rise. That will be the day of reckoning for the vampires. It will also be the day of decision by the zombie central bankers. Accommodate or not? Mass inflation or the Great Default?

My guess: mass inflation. Only when hyperinflation (above 25%) is the next stage, will central bankers make a serious attempt to cut off the funds. That is years down the road. The game of kick the can will continue.