Article / 21 October 2013 at 12:42 GMT

Rediscovering the price of money when things can't get worse

Chief Economist & CIO / Saxo Bank
Denmark

I’ve been starting my speeches for some time now by saying: “I am the most optimistic I have been in almost thirty years in the market—if only because things can’t get any worse.”

Is that true, and more importantly, how do we get a fundamental change away from this extend-and-pretend which prevails not only in Europe but also the world?

History tells us that we only get real changes as a result of war, famine, social riots or collapsing stock markets. None of these is an issue for most of the world—at least not yet—but on the other hand we have never had less growth, worse demographics, or higher unemployment since WWII. This is a true paradox that somehow needs to be resolved, and quickly if we are to avoid wasting an entire generation of European youth.


Photo: Eugene Ivanov
The West's central banks' policies are akin to Soviet-style central planning. Photo: Eugene Ivanov


Policymakers try to pretend we have achieved significant progress and stability as the result of their actions, but from a fundamental point of view that’s a mere illusion. Italian banks today own more government debt than before the banking crisis, leaving them systematically more exposed to their own government, not less. The spread on government bonds between Germany and Club Med is down below historic averages, but the price has been a total suspension of the “price discovery” of money.

The price discovery of money is the cruel capitalistic part of any system. An economics  textbook would call it the modus operandi by which capital is allocated where it can find the highest marginal utility. In practice, this should mean that the market dictates the price of money beyond one year—while at durations of less than one year, the central banks determine the price of money. The beauty of the system is that money is allocated in an auction where the highest bidder for “money” or “credit” gets filled on the price he or she deems to match his expected price of money.

Contrast the market-driven model with the present “success story” of relatively low sovereign spreads in Europe, which are driven by the European Central Bank president Mario Draghi’s promise to do "whatever it takes" to keep the euro out of trouble. He has threatened to activate the European Financial Stability Facility and the European Stability Mechamism plus the full arsenal of policy tools to ensure stability.

By doing so, he has effectively suspended price discovery for sovereign debt and for money, as the ECB and local central banks will provide infinite liquidity to local banks and hence indirectly to their government in any market conditions. This one-sided offer from the ECB and the market means there is no power to discipline the government with higher rates or to allocate credit more generally. We have simply disconnected the market and the price of money.

This comes after Draghi’s longer-term refinancing operation, a cheap funding for banks with little or no collateral, or the closest thing to quantitative easing you can have without calling it quantitative easing.

This is a problem because corporations that need to finance long-term projects, like building a power station over six to eight years, need a price for the credit they require throughout the building period. Right now they have an almost flat yield curve from zero to 30 years, which would be fine if it were realistic. But the problem is that one day in the “distant future” when the market normalises, interest rates should revert to their normal price, which is roughly inflation plus a risk premium.

In the case of an industrial company, an appropriate loan rate calculation could be something like: inflation plus Libor plus a risk spread, which might work out to about seven percent. Compare this with the rates available for highly creditworthy companies. Recently, Nestle  was able to issue a four-year corporate bond at 0.75 percent—the lowest ever. Yes, it’s nice for Nestle but remember the situation is created by the central banks presence in the market, not just due to the financial strength of Nestle.

A move from less than one percent to seven percent would administer an ugly shock to companies.  We have created a negative vicious circle in which not only investors, but also companies are depending on low interest rates forever. They have priced their future earnings and costs on government support prices rather than on realistic market prices.

The worst thing about the situation, however, is that the reason a blue chip company like Nestle can borrow at less than one percent in the capital market is the lack of alternatives for banks and investors. Less creditworthy small and medium enterprises (SMEs) which make up as much as 80 percent of many countries’ economies are not allowed to borrow. They are deemed too risky to lend to at the current “market rates” even though they hold the key to improving the employment and productivity picture.

They are willing to work cheaper, longer, harder and with higher risk tolerance in order to survive. So the remaining 20 percent of the economy occupied by large and publicly listed companies and banks gets 95 percent of all credit and 99 percent of all political capital. In other words, blue chips receive artificially low interest rates only because the SMEs don’t get any credit. Herein lies my continued belief in the my traditional opening statement: things must get better soon because they can hardly get any worse.

We have never been in a more dysfunctional state at the corporate, political and individual level in history. It’s time to realise that the reason capitalism won the war against communism in the 1980s was its strong market based economy—itself based on price discovery. Now the policymakers in their “wisdom” are copying everything a planned economy entails: central planning and control, no price discovery, one supplier of credit, money and the corollary effect of suppressing SMEs and even individuals.

Finally, history offers a compelling lesson: the last time the Federal Reserve engaged in a sizeable quantitative easing was in the 1940s. The low growth and falling inflation only reversed when the Federal Reserve stopped intervening due to a severe recession brought on by the policy mistakes of keeping QE in place too long.

In 2014, a bout of near or real recession in Germany and the US could kick start the price discovery mechanism again, which will help us to start healing the deep wounds left by years of policymakers compounding their errors with round after round of extend-and-pretend. Getting to the bottom is good in one sense: the only way is up.

By Steen Jakobsen

 

 

—Edited by Clare MacCarthy

4y
alpha yankee alpha yankee
well done ... the only way is up...? salvation through ascension to blue skies... Agree: "We have never been in a more dysfunctional state at the corporate, political and individual level in history." Agree : "central planning and control, no price discovery, one supplier of credit, money and the corollary effect of suppressing SMEs and even individuals."
4y
Steen Jakobsen Steen Jakobsen
Thkx Alpha...
4y
Jim Earls Jim Earls
Central Bankers remind me of this quote from Isoroku Yamamoto: "I fear all we have done is to awaken a sleeping giant and fill him with a terrible resolve."
4y
alpha yankee alpha yankee
He has not uttered such words, it is only a fake attribution in a movie regarding Pearl Harbor Attack... sorry but the issue is also not related to awaken a giant... but I guess you enjoy talking about giants... cheers.
4y
Jim Earls Jim Earls
It is very much attributable to a giant-a massive debt credit bubble that was born from misguided and distorted central banking hokum.
4y
alpha yankee alpha yankee
okay there is but this script is mentioning not of FED's policies in particular but macroeconomic cul-de-sac from a general point of view and their negative impacts on SMEs and individuals from not a monetary perspective but social perception...
4y
alpha yankee alpha yankee
lets take a spicemen from medicine: we have a patient suffering from diabetes mellitus he's a sugar addict a fat man this is the giant banks these banks are all addict of sugar videlicet QE money, and a part of brain that is FED unlike the ECB at the other lob of brain is trying to get rid of this sugar addiction by simply commencing a diet that is tapering, but whenever our patient happens to begin this diet he gets furious and feel himself stressful that is the reaction of markets to tapering try out in May... this idea suspends in the brain there is decisiveness but the brain is ironically happy of extreme sugar intake while the organs are being harmed that is US commoners and the economic periphery around them... to what extent this addiction can elongate ? first of all QE has been damaging US citizens and economic conditions of middleclass via stealing their welfare within a vesselage system of medieval ages; secondly this goes by until the health of US economy baddens further.
4y
alpha yankee alpha yankee
With reference to my previous message concerning spicemen from medicine, last thing to add is correlation of good US economic data with QE tapering is 180 degree opposite to what it intends to be... good US data cannot be a pretext of tapering QE because as long as the things go well in US economy QE as a harm factor to middleclass can go on by new versions such as QE-5,6...., but in fact worsening US data should be a concern for the beginning of QE tapering even ending, because QE itself is harming the economy and until this understanding is established as it should be QE seems to continue under disguise of different models and methods.
4y
alpha yankee alpha yankee
QE money doesnot flow into real economy and industrial manufacturing but directly make the stomachs of big banks swell ... the waste of all kinds of resources for the meaningless hunger of giants, maybe I am a part of this picture but I have never favored the wrong things going on... having excessive power is meaningless after it surpasses humanly requirements ... finally if I would to vote I would vote for total QE ending for market normalization but only in direct collaboration with ECB, G-7 and BRICS Central Banks. Look a whole city Detroit has faced with default... no QE money has ever helped them to survive... US has lost one of his toes, what if he loses an eye... then maybe he would be obliged to stop QE... but not before...!
4y
alpha yankee alpha yankee
What if we could begin a worldwide initiative.... a family composed of 5 persons having 100 millions of dollars asset would be the ceiling, and governments through signing an international agreement within the United Nations framework would accept to put limitations on the control of individual assets of families or persons having more than 100 millions of dollars asset through directing the excessive amount to cheap credit giving to SMEs, to implementation of manufacturing facilities or factories, to environmental sustainment projects under the jusrisdiction and surveillance of both the relevant individual and United Nations commisssionary composed of relevant authorized bodies. This would impede the waste of monetary resources in detriment of next generations' future, and provide them a liveable world; if only we could vote this initiative somehow, then we could rescue the redundant money from the captivity of banks and hot trading that generate no useful thing as a result.
4y
RYaN-1 RYaN-1
Apparently, you are not satisfied with the price of money in the countries of the North Europe. Ok, then try the South. The interest rates there may fit your expectations, but, as far as you know, with a bit of risk. ECB has to be a central bank for the whole Eurozone. You may have now to admit that this is a bold and irrational task, but this is the irrational concept of the European common currency.
4y
Bogdana Kovach Bogdana Kovach
Unfortunately small and medium-sized businesses are being supressed. The hope that the situation will be changed by politicians in the nearest future is subtle. So individuals can just use http://britainloans.co.uk/ to stay afloat without quiting business.
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