The decision to raise its short term interest rate by 0.25% to 1.25% a few days ago (April 7th, 2011) by the European Central Bank (ECB) will come to be seen as a major mistake, as some commentators are already suggesting. The official reason given by M. Trichet, the President of the ECB, was their concern over higher than anticipated inflation, with the evidence being the 2.7% headline rate of inflation in the Euro area in the year ending in March,the same as the US, where the March headline Consumer Price Inflation (CPI) also came in at 2.7%.
However, the different decisions of the US Federal Reserve, which left its short term rate at its all time low of 0-0.25%, and even of the UK, where a 4.4% headline figure for March was not enough to persuade the Bank of England to raise its rates from their 0.5% level, to the ECB demonstrates how much different countries’ histories dictate their response to inflation. In the German-dominated ECB, the spiritual heir of the Bundesbank, inflation is always and everywhere the principal enemy. This is understandable, given that Germany experienced not merely the famous Weimar Republic hyper-inflation of 1922-23, but also the post World War II hyper-inflation, when cartons of Lucky Strike cigarettes from the occupying Allied forces were the most valuable currency. The successful currency reform that introduced the Deutschmark in 1949 by Ludwig Erhard, Chancellor Adenauer’s finance minister, set the scene for West Germany’s Wirchtshaftswunder economic revival in the 1950s and 1960s and gave the Germans, and by extension, their EU partners in France and the Benelux countries, a stable currency for the first time in a quarter of a century.
The Anglo-Saxon economies of the US, Canada and the UK, by contrast, had the deflationary experience of the Great Depression as their residual folk memory of the dangers of economic mismanagement. As a result, their central banks ahve always chosen inflation as the lesser of economic evils when faced by challenges, which is why their currencies have generally been weak against the Deutschmark and its successor, the Euro. Sometimes, however, the European suspicion of inflation has led to obviously mistaken decisions on interest rates. The ECB, readers may recall, chose to raise rates in mid 2008, 3 months after Bear Stearns had collapsed, and over 2 years after the US housing market had begun to slide. When Lehman Bros. went bankrupt 3 months later, the ECB was forced into an abrupt reversal, as it became apparent that the commodity-inspired headline inflation which had led them to raise rates was being overwhelmed by the collapse of the global financial system, and the danger, especially to European banks which had large exposures to overextended European property markets such as Ireland, Portugal and Spain, was not inflation but deflation.
It seems likely that the same story is repeating itself now. What helped prevent the collapse of banks in Europe, just as much as in the US and the UK, was central banks dropping short term interest rates to very low levels and committing themselves to leaving them there for a long time. This allowed the banks to ride the yield curve, borrowing virtually unlimited amounts from co-operating central banks and reinvesting with lots of leverage in “risk free” government bonds paying a higher interest rate. This is what enabled the banks to survive , and to generate big enough profits to allow them to write off their losses on sub-prime mortgages, credit default swaps and other defaulted loans. This is what enabled the banks to raise lots of new capital in the stock markets as their share prices rebounded, and to pay their employees generous bonuses once again.
However, once central banks begin raising short term interest rates, or even be suspected of thinking of doing so, the game is over. As the spread between short term and longer term interest rates narrows, profits are reduced, and bond prices fall, turning the wonderful guaranteed profits from riding the yield curve into much more uncertain returns. Banks will not be as willing to buy government debt, which, as economists such as Andrew Hunt (www.andrewhunteconomics.com) have pointed out, is what has been funding the deficits of European countries, especially the peripheral ones such as the members of the PIIGS (Portugal, Ireland, Italy, Greece and Spain). When the ECB stopped providing short term liquidity freely through its emergency funding mechanisms this time last year, the Greek ouzo crisis erupted, as without the access to virtually free short term funding, European banks would not continue to buy Greek government debt. The malaise has now spread to Ireland and Portugal, and the irony of the situation is that the ECB has ended up back-stopping the new emergency funds such as the European Financial Stabilization Fund (EFSF) facilities. The fact that it raised interest rates this year the week after Portugal admitted defeat on cutting its expenditure and applied for a bailout indicates that, like Bourbon kings of France when they returned after 25 years of exile in 1815, the ECB has “learned nothing and forgotten nothing”.
Incidentally, the Portugese government and the Irish government that tried to apply the austerity measures demanded by the ECB (and IMF) were thrown out, and Chancellor Merkel’s CDU-CSU coalition has suffered several defeats in provincial elections in the last year, since the EU started trying to bail out its weaker members, including a defeat in Baden Wurttemberg, which the CDU had governed since 1952. The political classes in Europe, such as German finance minister Wolfgang Schauble, are now openly talking about some form of restructuring for holders of Greek government debt, which drove 2 year debt down last week to a price of 79.1 and 10 year debt to 62.6%, representing yields to maturity of 18.44% and 13.6%, assuming, as the Financial Times noted, that the bonds are repaid in full and on time. Portugal’s 10 year notes are yielding 8.737% and Ireland’s, which was downgraded by Moody’s to one notch above junk last week, at 9.288%. European banks’ balance sheets contain major exposures to these and Spanish and Italian government bonds, all still held at book value on the assumption, made during the “stress tests” of large banks last year, that the bonds will be repaid on time and in full. This seems more and more unlikely, and the ECB’s decision to raise interest rates will help to bring the crisis to a head sooner than would have otherwise been the case, as in 2008.