Several of the major central banks are caught in a trap of their own making.
These include the US Federal Reserve, Bank of Japan, European Central Bank and others.
The credit-based global financial system that we have built and participated in over the past century must continually grow or die. It’s like a chair game that we have to keep adding people and chairs to so it never stops.
This is because the cumulative debt is far greater than the total currency supply, meaning there are more calls for currency than there is currency. Therefore, never too many of these claims can be made at once; The party must always go on. When the debt is too large relative to the currency and drawn on, new currency is created as it costs nothing more than a few keystrokes to produce.
For most major countries it is like this:
Chart Source: St. Louis Fed
In other words, claims for dollars (debt) are growing much faster than the economy’s ability to generate dollars and are far greater than the amount of dollars there are. When this becomes a problem, the central bank simply increases the base money supply.
Base money is a central bank liability and is used by commercial banks as a reserve asset. Broad money is the liability of commercial banks and is used by the public as a savings account. Government bonds are liabilities of the federal government and are used as collateral by the central bank and commercial banks.
In other words, liabilities are secured by other liabilities to the end.
Additional literature on this:
Central banks are putting guard rails on either side of this credit growth, trying (and often failing) to ensure that it doesn’t spiral into a bubble or spiral into a deflationary default too quickly. They want smooth credit growth with maybe some mild cycles along the way and a smooth 2% annualized currency depreciation.
When economic growth was sluggish for decades, central banks lowered interest rates and encouraged more credit growth (aka debt accumulation), leading to spurts of economic growth. Whenever the economy was booming, they would raise interest rates and stunt credit growth to try to cool things down.
The problem is that this micromanagement, with the understanding that the core system would always be bailed out if needed, has contributed to ever higher debt-to-GDP ratios, both private and public, and ever lower interest rates.
Over the past four decades, the increase in debt over time has always been offset by interest rate cuts, so the debt service costs never really went up.
Eventually, however, all major central banks reached zero or even slightly negative interest rates, and realistically there was no lower rate. Further increases in debt at this point would be unlikely to be offset by lower interest rates. Indeed, the cost of debt servicing relative to GDP and income would start to rise.
Furthermore, if the world ever suffers a significant drop in productivity, such as from deglobalization or underinvestment in commodities, which we are now witnessing, the resulting inflation would be difficult to offset by raising interest rates.
Chart source: YCharts
We haven’t seen this disparity between inflation and interest rates since the 1940s, the last time public debt as a percentage of GDP was as high in developed countries as it is today.
Much like in the 1940s, then, many central banks in developed markets are trapped. They cannot permanently raise interest rates above the prevailing rate of inflation and are instead stuck with slowly rising interest rates, breakneck forward guidance, yield curve control and trying to inflate some of the debt away.
However, the European Central Bank has arguably the toughest job of all.
This was very clear in the head of the ECB, Christine Lagarde last job interview.
She was asked, “How do you get the balance sheet down?” while the ECB balance sheet is displayed on a screen.
Chart source: Trading Economics
She replied, “It will come. it will come In due course it will come.”
The interviewer paused in confusion and then asked, “…how?”
And she replied, “In due course it will come.” And then she smiled.
She offered no answer, no description, no explanation, and had rather awkward facial expressions throughout the conversation.
Because like most central banks, there is no plan. It won’t come. Treasury bonds will be monetized to the extent required or they will collapse. And it’s particularly tough for the ECB because it has to monetize the debt of certain countries more than others.
A monetary union without a fiscal union
The countries of the euro zone have given up their monetary sovereignty. Instead of keeping their own currencies, they have agreed to use a common currency and thus a common central bank.
This had advantages and disadvantages, but due to its structure it was politically unstable from the start.
The United States can unilaterally print dollars. Japan can print yen one-sided. Their governments can heavily influence their central banks when needed. But Italy, for example, cannot print euros alone or strongly influence the ECB.
At first glance, this doesn’t seem all that different from US states. Texas, California, New York and other states cannot print dollars. So what’s the big deal if eurozone countries can’t either?
Well, the difference is that in addition to a common monetary union, the US mostly has a common fiscal union, while Europe mostly doesn’t have a common fiscal union.
US states share most of the same pension, entitlement, and defense systems. Residents of every state contribute to Medicare and Social Security, as well as the US Armed Forces, which together make up the majority of federal government spending. Citizens of the US are not citizens of any particular state; They are free to move around the country under what is largely the same entitlement system. In contrast, these entitlement systems differ greatly between European countries.
At the end of the day, it’s the debt differential from this lack of fiscal union that matters. European countries had higher debts when they became a monetary union and it has only increased since then.
Here are the top five US states by GDP, as measured by their national debt as a percentage of state GDP.
- California: 5%
- Texas: 3%
- New York: 8%
- Florida: 3%
- Illinois: 7%
And here are the five largest European countries by GDP, measured by their public debt as a percentage of their national GDP:
- Germany: 70%
- France: 113%
- Italy: 151%
- Spain: 118%
- Netherlands: 52%
The percentages for both US states and European countries can be increased further if we take into account future expected off-balance sheet claim liabilities. These are basically debts that have not yet been marked to market.
But regardless of how we calculate it, there is a yawning difference between the debt levels of US governments and the debt levels of European countries. In the US, government debt is mainly held at the federal rather than state level, while in Europe, government debt is held primarily at the individual country level and they do not have individual central banks with unilateral ability to create base money.
This shows that the situation on this point is hardly comparable. Most US states do not need Fed debt monetization to remain solvent. At some point, some may face pension bankruptcy, but that’s not quite such a structural problem. However, several European countries require continued monetization of debt by the European Central Bank to remain solvent year after year.
To put it bluntly, the US has a lot of problems. I have written numerous articles on how the petrodollar system has weakened US manufacturing more than, for example, the rest of the developed world. In contrast to Europe, the US has had a structural trade deficit and a strongly negative net foreign asset position for decades. The US is also more financialized than Europe in the sense that our stock market is big enough to affect our economy, and not just the other way around. We are so consumption-oriented, stock-oriented, and dependent on the outside sector to recycle our trade deficits into our capital markets that, in that sense, “the tail can wag the dog.”
But in terms of the specific ability to stop monetizing government debt for certain periods of time, the ECB is pretty far down the field compared to other central banks. It’s a more complicated political issue.
Robin Brooks, chief economist at the Institute of International Finance and former chief FX strategist at Goldman Sachs and former chief economist at the IMF, has some of the best charts to illustrate this problem. The solvency of Italy’s sovereign debt is in the hands of an entity, the ECB, over which Italy has no unilateral control:
In the long run I can’t see myself being a European investor and having any significant long term exposure to the currency, particularly in some of the southern European jurisdictions.
I would much rather have real estate, profitable stocks, commodities, gold and bitcoin than euros and eurobonds. The same is true for the US, Japan and other countries, but with Europe, the currency brings additional tail risks, especially now that its energy security is being seriously tested.
Chart source: YCharts