Markets have fully adjusted to a financial world which reflects the leadership and management of money by central banks, and are increasingly frightened of any prospect of their control failing.
Every time the system stumbles, the response has been for central banks to force greater control and regulation upon the monetary system to the detriment of free markets. It is the financial version of the Road to Serfdom. Central banks have become ill-equipped to allow markets to price risk, and in the case of the ECB, it is downright hostile to market-determined prices.
The ECB is a creature of the EU. The EU super-state has legal primacy over the consumer in determining consumer, market and monetary affairs. I was alerted to the full implications of this fact when I recently chaired a presentation of a remarkable paper written by a barrister, Ben Wrench, sponsored by the Institute for Direct Democracy in Europe. Wrench’s paper is worth reading to appreciate its full implications, and it can be found on the IDDE’s website.
He describes EU citizens as being subject to rule by law. Unelected representatives legislate and regulate whatever they wish, and democratically elected representatives have no right to challenge them. This is why referendums and parliamentary votes are ignored, because they have no right of challenge in law. This contrasts with the UK’s rule of law, whereby everyone, including the state, has to abide by laws and regulations decided by democratically elected representatives.
On the EU mainland, the Code Napoléon applies, where the underlying legal approach is that everything is illegal unless it is permitted by law. The UK’s laws are diametrically opposed, because everything is permitted unless it has been made specifically illegal. The EU is all about the primacy of the state over the people, while in the UK the basis is one of laissez-faire. This is the difference between rule by law and the rule of law.
Having made this important point, we must move on to the economic implications. Legally, the Anglo-Saxon market-based approach, which is applied to global markets, has its basis in English law. The EU regards markets, in which consumers determine their free choice, as an Anglo-Saxon culture that is rife with unwelcome financial speculation and profiteering, and must be suppressed. This is what informs the ECB. When Mr Draghi famously remarked that he would do “whatever it takes”, he was empowered to do so, because of the rule by law, with which the ECB governs markets under its control.
In Europe, it is the Anglo-Saxon approach to the rule of law that is out of step with the ECB. While there is everywhere a tendency for the state to gravitate towards central planning of markets, at the ECB it is also enshrined in that institution’s legal approach. There is no mechanism to stop the ECB from intervening to set prices in financial markets, wherever and whenever it chooses, despite the grumbles emanating from Germany. The ECB will take no lessons from the speculators and profiteers, and as a result has become wholly detached from understanding what markets are about.
It is this institution that presides over the individual central banks of the Eurozone members, which are equally bound by the Code Napoléon. Any hope, that the ECB and the national central banks are culturally capable of handling the developing financial crisis in Europe, must be abandoned. It will only be a matter of time before the monetary embodiment of the Code Napoléon, the euro itself, is finally confounded by market reality.
Markets always win in the end, but the journey to the euro’s destruction will have twists and turns. The management of markets by the ECB is causing a hidden run on the shadow banking system, which is leading to demand for cash to replace credit. No one knows the true size of the Eurozone’s shadow banks, partly because they are hard to define, and partly because attempts to quantify it focus on only six Eurozone member states. But we are talking of huge numbers.
According to the most recent report on shadow banking by the Financial Stability Board[i], the six Eurozone countries[ii] included in its assessment of total shadow banking assets is 23% of the $80 trillion global total[iii], amounting to some $18.4 trillion equivalent. At the heart of the euro area’s shadow banks is sovereign debt, which because of the ECB’s quantitative easing purchases, is being priced substantially in excess of risk-determined levels.
By depriving the shadow banks of this vital collateral, they are being forced to reduce their activities in the areas where it forms the basis of their business. To appreciate the importance this effect has, an understanding of the purpose of shadow banking is required, and it can be summed up in one sentence:
If a central bank starves the shadow banks of high-quality collateral against which it issues credit, the system’s ability to expand credit goes into reverse gear, restricting their ability to defer settlements. Demand for cash must therefore rise. That is why euros, and yen for that matter, have become today’s strongest currencies in recent months as this effect has begun to bite.
It is assumed by financial commentators that the ECB, by introducing an interest rate penalty on cash and bank deposit balances, is encouraging spending to increase and for the euro to weaken against the dollar. That may or may not be the case, but it is not the major issue. Far more important is the ECB’s continuing need to assert tight control over euro-denominated bond markets. This means that bond prices must not be allowed to fall. And having already mispriced the whole market structure to suit its own ends, the ECB is fully committed to continuing with this monetary policy. It therefore cannot allow the evil Anglo-Saxon speculators and profiteers to act beyond the law, under which the ECB imposes its customary control. Nor can it modify monetary policy to help out the shadow banks.
Things are coming to a head. The share prices of systemically important banks are reflecting this new stress, and they are under considerable pressure. The Italian banking system is closer than ever to collapse, and Austria last week was forced to bail-in Heta, a bad bank created out of the Hypo-Alpe-Adria bail-out six years ago. The inconvenient truth is that notwithstanding the ECB’s whatever-it-takes hype, markets always prevail in the end, and that is the reality the culturally different ECB is now facing.
It is a similar situation in Japan. According to the FSB’s report, Japan’s shadow banking system is approximately $5.5 trillion equivalent, and the Bank of Japan is squeezing markets even harder. JGB bonds of up to twelve-years’ maturity have negative yields. As in the case of the euro, the yen is immensely strong, because contracting credit in the shadow banking system is forcing deferred settlements into cash.
In Japan’s case, the BoJ has a very bad dose of deficit-financing religion, and has followed the advice of similarly-afflicted macroeconomists to increase monetary and fiscal reflation until it works. It hasn’t worked since the stock market collapsed in 1990, and Japan’s failed economic policies have driven her into a massive debt trap from which there can be no other escape, other than to collapse the currency.
It would appear the ECB similarly has no exit other than the destruction of the euro. So far, both central banks have deferred the consequences of their monetary policies by banning risk. They dare not permit bond markets to price risk properly, nor can they cease their bond purchase programmes in order to ease the pressure on the shadow banks. Otherwise, a lethal combination of falling bond and asset prices, sharply escalating perceptions of risk, and higher borrowing costs for over-indebted borrowers could require the major central banks to underwrite the entire global banking system. The distance between where markets are priced now and where they would be without monetary intervention appears to be unbridgeable.
Instead, the ECB and BoJ can only continue to muddle along, suppressing all attempts by markets to price risk for what it actually is. The best outcome, if it were possible, would be for a carefully planned and gradual retreat to market pricing, in the hope the pace of value destruction will not be destabilising. Good luck to that. The chances of pulling this off are negligible, not least because of the anti-market culture in the central banks generally, and at the ECB in particular.
Shadow banks, commodities and gold
Restrictions on the creation of credit in the shadow banks are bound to reduce liquidity in futures, forwards and over-the-counter derivative markets, restricting synthetic supply of commodities. This could be a recent factor influencing commodity markets generally, and why they might continue to rise more sharply than underlying economic conditions suggest is reasonable. The gold price as a bell-weather seems to be defying the normal checks on its price, and appears to have entered a new bull phase.
The Bank for International Settlements’ Table D5 derivatives report confirms that the notional amounts outstanding of OTC gold contracts at the banks has contracted from $341 billion to $247bn between H2 2013 and H1 2015. The current position will only be revealed in about a year’s time, but it does indeed appear that the days of putting a cap on commodity prices by inflating outstanding derivative quantities is over.
Given that this is the case, together with the growing risk of a second banking crisis, a future can easily be envisaged whereby perceptions of risk shift against bonds, equities, property and currencies, and in favour of commodities, particularly gold.
[i]Global Shadow Banking Monitoring Report 2015
[ii] Ireland, France, Germany, Netherlands, Italy and Spain.
[iii] The FSB has changed its methods to estimate a narrow and a broad measure. This figure is comparable with prior methods.
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