A Monetary Cancer Metastasizes in Europe

The European Central Bank again cut the interest rates it controls. Notably, the deposit rate was moved deeper into negative territory. It is now -0.2% (minus 20 basis points, that is not a typo). The ECB says it’s trying to nudge prices higher, but it’s actually feeding the cancer of falling interest.

The linked article above, like most, is focused on the quantity of euros and the presumed direct relationship to price. The following bit of editorializing from that article is uncontroversial in Frankfurt, London, New York, Mumbai, or Shanghai.

“Inflation weakened to a five-year low in August, just 0.3% in annual terms. That is far below the ECB’s target of a little under 2% over the medium term, raising fears that the region could face a debilitating stretch of weak or falling prices that hampers debt-financing and investment. Those fears intensified as market-based measures of inflation expectations weakened, too.”

Every assumption in this short paragraph is wrong. One, inflation should not be conceived as rising prices. There are many reasons for prices to rise or fall that have nothing to do with the currency. For example, every business is constantly working to cut costs. Without monetary debasement, and a steady stream of onerous new regulations, prices would be falling.

Two, inflation is monetary counterfeiting. Inflation is the fraud of selling a bond into the market, when the debtor lacks the means or intent to repay. The deadly danger is that it seems good to creditors who buy it, often using leverage. Eventually, every fraudulent debt will default.

Three, central banks keep trying to engineer rising prices, in the name of some sort of good, like Stalin and his Five Year Plans. The economic theory that demands this is frivolous at best. There is no there, there. This does not stop the central planners from trying their worst anyway.

Four, it should be obvious by now that central banks do not have control over prices. If they did, we would not still be struggling with prices that stubbornly refuse to rise. How many times has the ECB tried to get prices to rise since the last acute phase of the monetary crisis?

Five, falling prices do not hamper financing or investment. Look at the massive investment in first electronics, then computers, then computer networking, and most recently communications. Prices have been falling, for a long time and by a large amount even in nominal dollars.

Finally, we must distinguish between the prices of consumer goods and the prices of assets that are bought with leverage. The latter is a threat to those who borrow short-term to finance long-term assets. For example, when a real estate developer sells 3-year bonds to buy a large commercial building. Since the developer can’t amortize the debt in three years, it will roll its liabilities—sell new bonds to pay off the old ones. This is a form of counterfeit credit. One way to get in trouble is if the market value of the property falls. Then the bonds cannot be rolled.

These are some of the errors in the conventional, quantity analysis approach. It’s the wrong approach, though it seems intuitive. Suppose we think about wheat. We consider if we had ten huge bags of grain how would we feel if a truck pulled up to attempt to deliver the 11th. Or if we had a basement full of copper bars and contemplated buying more. No one wants to bury himself under a hoard of useless stuff.

Money is not like any commodity. No matter how much money we have, the thought of receiving a big check in the mail is exciting. We don’t think we have too much money already. Even the most die-hard gold bug, is eager to sell you his newsletter in exchange for dollars. No one rolls his eyes or sighs at the prospect of making more money.

We cannot assume that a rise in the money supply translates into a rise in prices. It might or might not. However, there is a danger in focusing too much on prices, and missing the terminal monetary problem. Imagine a doctor obsessing over a patient’s body temperature. He could easily miss the signs of cancer.

I saw a different approach in an article this week. The author suggests that rates on government bonds are now negative, because investors trust they will get their money back. Presumably, this school of thought regards the US government as less trustworthy because the Treasury bond pays a higher yield. This approach is also wrong.

Let’s take a look at the yield curve in Germany.

bund yield curve

There is a reason why the yield on government bonds in Europe is falling to zero and below. Banks have a choice to hold cash or government bonds, with the main factor being liquidity. However, when the ECB lowers the deposit rate for bank cash to below zero, this changes the incentive. The lower the yield on cash, the more the banks will tend to prefer bonds.

I am no European political expert, but perhaps this is the intent of the ECB. Perhaps they would simply like to buy more government bonds, but cannot or dare not due to treaty, law, or politics. But they clearly have the power to create incentives for banks to do it.

The right approach to understanding what’s happening in the euro begins with the observation that a paper currency like the euro is a closed loop system. You may think that you can protest a negative interest rate by getting out of the currency. For example, you can buy antique Ferraris, paintings, real estate, stocks, a foreign currency, or even gold. This may protect you personally, but it does not alter the trajectory of the interest rate.

The former owner of the asset is now the owner of those euros. What will he do with them? Deposit them in a bank. What will the bank do? Buy a bond. At one time, all roads led to Rome. Today, all monetary roads lead to the government bond that backs the currency.

We are all disenfranchised by the regime of irredeemable money. The central bank may have some control. Or, as I argue in my theory of interest and prices, they have little control but set up a positive feedback loop that drives interest to zero. However, the people have no control. The rate has been falling for decades, pushed down by massive forces beyond even the control of central banks. The price of the bond, and hence the interest rate, is set free from constraint.

Consider for a moment, the price of wheat. If the price falls below the cost of growing, then farmers stop planting it. Alternatively, if the price rises above that of other starches, then manufacturers will stop buying wheat. The cost of wheat and every other real thing is dependent on the price of oil, machinery, labor, and many other inputs, it is tied to everything else in the economy.

By contrast, the bond price in a paper currency is not tied to anything. It could collapse and give us an interest rate of 17%. Or it could have a 33-year bull market, and give us an interest rate below 1% (the bond price is inverse to the yield). The rate can keep falling.

There is a cancer metastasizing in the body economic. Zero interest is creeping out from the short-term credit facilities provided by central banks. In Germany, it is now out to the 4-year bonds. Zero interest on overnight deposits is like gangrene in your fingernail. When it hits the 1-year bond, it is spreading to your whole finger. The 2-year bond is like the lower part of the hand. The German 3-year bund now has a negative yield. The all but zero-yield on the 4-year bond is like rot moving up towards your elbow.

What will they do when necrosis spreads up to the shoulder and beyond?

We need a new concept to understand the nature of the problem. The burden of debt is a measure of the pressure on debtors. The net present value of a stream of future payments depends on the interest rate. This is not just the interest rate at the time the asset was purchased. The present value should be recalculated whenever the interest rate changes. Each time the interest rate falls the net present value rises.

This seems good for the bond speculator, who gets a capital gain. However, this is a zero-sum game. His gain comes at the expense of the bond issuer. The bond issuer feels an increase in his burden of debt as rates fall. With each halving of the rate of interest the burden doubles. Of course, the falling rate is also an incentive to borrow more, because the monthly payment is lower. Debtors owe more euros of debt, and the burden of each euro owed is doubling. Here is a graph of the history of the German 10-year bund, a reasonable way to measure burden of debt.

ten yr bunds

In June of 2008, the 10-year bund yielded 4.5%. This is labeled point 1. By August of 2010, point 2, the rate was cut in half to 2.25%. The burden of every debt in Germany—and arguably Europe—doubled. In July of this year, it was lopped in half again to just about 1.13%, at point 3. Now it is 0.94 and well on its way to the next milestone of 0.56%. Not coincidentally, Japan is already there.

This burden of debt is one of the most important concepts, because the entire basis of the system is debt. One man’s debt is another’s asset. The ultimate asset is the debt of the government. If debtors begin to default in earnest and if one default causes others in a cascade, then the system can collapse like dominoes.

The analogy of dominoes is apt because creditors are themselves debtors. They are typically leveraged, so a small loss can cause insolvency.

The financial system must collapse—necessarily so—when the interest on the long bond hits zero. Debtors cannot hold up an infinite burden of debt, and that is what a zero long-term rate means.

Consumer prices in Europe may continue to eke out small gains, especially as the carry trade begins to press down the value of the euro compared to the dollar. Or prices may begin to fall, perhaps slowly.

Either way, who cares? The patient’s arm is turning black.


The Gold Standard Institute Presents The Gold Standard: Both Good and Necessary, in Manhattan on Nov 1. You are cordially invited to join us for a discussion of ideas you won’t get anywhere else. The gold standard is the monetary system of the free market—of capitalism. Dr. Andy Bernstein, a rock star of the liberty movement, shows why capitalism is good. In my talk, I explain why capitalism is impossible with fiat money, and why we have not recovered from 2008, and we won’t without gold.

6 replies
    • Mark says:

      Your article puts ‘meat on the bone’ from a previous article of yours explaining how in a fiat currency a debt cannot be extinguished. As fascinating as it is excruciating. Thank you again.

  1. bgoldman says:

    I really like this article, but I am greatly confused by your comments on “debt burden”. You say there is an inverse relationship between the interest rate and the burden, and that low long-term rates create an increased debt burden.

    But, intuitively, this makes no sense to me. I know that if I refinance a given principle at a lower rate, then a smaller fraction of my income will be consumed to service the interest on that debt. Thus, I feel like my debt burden is reduced by the lower rate, not increased. Granted, I could choose to borrow more at the lower rate if I wanted my debt burden to remain high, but why would I do that? Certainly I am not forced to do that.

    Can you help me reconcile this?

    • Greg Jaxon says:

      @bgoldman: The bond debt Keith is discussing differs from your mortgage debt under US law. The mortgage contract includes a pre-payment clause that limits its value to the creditor. By contrast, to “refinance” a bond, one must buy it back – a step that fully prices the remaining burden of the debt at present interest rates. When discussing corporate debts and sovereign debt the rules for bonds apply. Indeed it is because they are a stronger contract that they can be priced as low as they are initially. Your mortgage creditor took a lot of your “refinancing” benefits as payment up front and in increased interest payments. You did not obtain a mortgage at the going rate of AAA corporate bonds.

  2. drdavis2 says:

    I, too, am struggling with the concept that the burden of debt increases as interest rates fall. Could someone please give much more detail with specific example of how this burden exerts itself? Also, if this burden is so clear, why does hardly anyone seem to be aware of it?

    • Keith Weiner says:

      Thanks for the comments and questions.

      The problem comes when you borrow money, and subsequently they lower the rate. This doesn’t help you. You are stuck at a higher rate than your competitors (think corporations selling bonds, not homebuyers). Your competitors have a permanent competitive advantage and there’s nothing you can do. They can either borrow more for the same monthly payment, or borrow the same amount for a lower payment.

      I have written about this in several places, including a short piece for the Gold Standard Institute USA:

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