Yanis Varoufakis: It is Now Official – The Eurozone’s Monetary Transmission System is Broken

By Yanis Varoufakis, Professor of Economics at the University of Athens. Cross posted from his blog

Under normal conditions, the interest rates that you and I must pay on a home loan, a car loan, our credit card, a business loan are pegged onto two crucial rates. One is the rate that banks charge one another in order to borrow from each other. The other is the Central Bank’s overnight rate. Alas, neither of these interest rates matter during this Crisis. While such ‘official’ rates are tending to zero (as Central Banks try to squeeze the costs of borrowing to nothing), the interest rates people and firms pay are much, much higher and track indices of fear and subjective estimates of the Eurozone’s disintegration.

Following the Crash of 2008, banks stopped lending to each other, fearful that they will never get their money back (as most banks became, in effect, insolvent). Thus, the interest rate at which they lend to one another simply ceased being a meaningful price (just like the prices of CDOs, following Lehman’s collapse, lost their meaning as no one bought or sold those pieces of paper). The truly scandalous aspect of the Libor scandal of recent weeks is that banks continued to use (and ‘fix’) an estimate of the interest rate at which they lent to each other (for the purposes of fixing all other interest rates; e.g. mortgage and credit card rates) when they did not lend to each other any more…

The demise of Libor and other measures of inter-bank lending interest rates left us with the official interest rate of Central Banks, like the European Central Bank. Recently, in an acknowledgment of past errors and of the strength of the European austerity-induced recession, the ECB lowered its key interest rate to 0.75% – the lowest level since the euro’s inception. At the same time, the ECB did something else that is extraordinary by its own standards: it reduced to zero the interest rate it paid private banks for depositing money with the ECB.

Under normal conditions, such an aggressive interest rate reduction would drag downward all interest rates: with private banks being able to borrow at a pitiful 0.75% from the ECB to lend on to the private sector, and having no incentive whatsoever to park their idle capital with the ECB, one might have hoped (as the ECB’s President, Mr Mario Draghi, clearly did) that banks would be more willing to lend and at a lower interest rate. However, such hopes would have been baseless. Indeed, the interest rates paid by households and companies remained high, the banks’ funding costs even increased, and the normal ‘monetary transmission mechanism’ (i.e. the system that converts lower official Central Bank interest rates into an increase in the supply of money) proved to be broken and beyond repair. The question is: Why?

Here is the answer, as provided by Christian Noyer, a governor of the Central Bank of France (in an interview with Handelsblatt): “We are currently observing a failure of the transmission mechanism of monetary policy. From the markets’ perspective, the interest rate facing individual private banks depends on the funding costs of the state where they are domiciled and not on the ECB overnight interest rate… Hence the monetary policy transmission mechanism does not work.”

Now, this is an admission that should be on every headline in Europe, given that it comes from a governor of the Central Bank of the Eurozone’s second largest economy. It is equivalent to a pilot picking up the intercom and saying to the passengers: “The landing gear has failed.” And as if this were not enough, Mr Noyer added for good measure: “We did our best to face up to this phenomenon which is unacceptable for a Central Bank in a monetary union.” What did he mean by that? The clue comes from his follow up sentence: “In future we cannot rely endlessly on a system where the Central Bank is injecting massive liquidity to the banking system, boosting hugely its balance sheet.” Clearly, Mr Noyer was referring to the LTRO; the ECB’s attempt earlier in the year to ‘fix’ the ‘transmission mechanism’ by pumping 1 trillion euros of liquidity into the Eurozone’s banks. Reading between the lines, it is clear that, at least according to Noyer, this ploy failed (as some of us kept saying it would).

In summary, borrowing costs in the Eurozone have lost their two anchors: the inter-bank lending rate (courtesy of the sad reality that the banks no longer lend one another) and the overnight ECB interest rate (which banks ignore when lending). The key to understanding this breakdown is governor Noyer’s phrase “the interest rate facing individual private banks depends on the funding costs of the state where they are domiciled and not on the ECB overnight interest rate”. In short, the fear of a disintegration of the Eurozone (that is aided and abetted by silly talk of Greece’s and Portugal’s expulsion) has broken the umbilical cord that normally connects the ECB’s overnight rate with actual borrowing costs of the private sector. Now, the later reflect the fear that the member-state in which the firm or the household are will not be able to refinance itself. In a never-ending circle this fear ensures that the said member-state will not be able to refinance itself and, crucially, guarantees the ECB’s failure to lower interest rates even when it pushes its official rates to zero. This is what a monetary union on the verge of collapse looks like.

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  1. Ian Ollmann

    How much of the money borrowed from governments went back in to buy government bonds? Why lend money to unknown people when you can just borrow mountains of money from the government and lend it back to them at a higher rate.

    It all looks too good to be true until it looks like the euro governments can’t pay their debts. How much more of this nonsense needs to continue until (solvent) governments nationalize the role of lending to business?

    1. Nathanael

      The solution, in policy terms, remains simple. The ECB should
      (1) print a boatload of money
      (2) hand it to all the EU members (wiping out the government debts)
      (3) Finance government-owned banks which lend directly to businesses and individuals, to compete with the broken, defective private banks.

      This is essentially the New Deal recipe. The US should follow it too, and it would be easier for the US because we don’t have the inter-government cooperation problem.

      There is a political problem which prevents this from being done. That is one of the two political problems we must solve. The other is the political problem which prevents governments from doing anything about global warming.

  2. Hugh

    This post gives one of the two reasons why the Eurobanks aren’t lending. The other is demand destruction.

  3. hermanas

    When labor strikes, the troops are called in.
    When capital strikes, we get handwringing.

    1. hermanas

      I’ll re-phrase that.
      When capital strikes, we get hand-wringing.
      When labor strikes, the gloves come off.
      What’s the definition of justice?

  4. Yearning to Learn

    The answer is and has been obvious for some time. Nationalize the banks.

    the transmission mechanism is broken because the banks don’t trust one another. They don’t trust each other because they all know that every last one of them is insolvent.

    The only thing that makes the banks liquid (not solvent) is their support from their local governments (guarantees, etc). Their reliance on their local State for liquidity explains why their lending and borrowing costs mimic the borrowing ability of their local government, and not that of LIBOR or Central Bank rate.

    this phenomenon has been seen before in prior zombified banking systems.

    Any money sent to current TBTF banks just dies in the black whole of old liabilities. The only way out of it is to let the banks fail and start with new banks that don’t have the horrific liabilities.

    of course, it doesn’t help that we have continued demand destruction due to policies that continue to favor capital over labor, but that is an argument for a different thread.

    1. Nathanael

      FDR fixed this by starting his OWN banks. (HOLC, FNMA, etc. — the reorganized RFC counts too) People knew that the government-backed banks could be trusted, even though the private ones couldn’t.

      It’s interesting discovering how long we’ve been fighting the fight over control of money. People understood the issues *better* in the 1930s than they do now:


  5. steve from virginia

    Good grief!

    – First of all, the rates of interest are in essence rules rather than conditions. Gravity is a condition, so is resource exhaustion. Interest rates are determinable by negotiation as well as by fiat, they can be changed any time. What determines interest rates are rules.

    – The rule regarding the interest cost of money is that cost is inverse to the size of the amount borrowed. This is an advantage for larger enterprises which can obtain lower-cost money than their competitors (in question are much smaller). See ‘Walmart’ …

    – The interest cost of money is irrelevant as money is priced by exchange for petroleum world-wide by hundreds of millions of motorists every day. Since 2004 crude oil cost is the money cost. As a consequence, central banks are irrelevant. There has been no effective central bank monetary transmission, central bankers have been unwilling to acknowledge this fact: resource depletion is a condition there is no way to adjust it.

    – The forex implications of inflexible, close-coupled monetary policy can easily be gauged with the ‘unholy trinity’ (or impossible trinity). There can be no independent monetary policy without the country- or countries ‘going off’ crude oil (and de-industrializing) first.

    – This de-industrialization process is underway in Greece, BTW.

    – Interest cost AND petroleum cost have the same monetary effect: there is the upper-bound. There are either too-high interest rates or too-high petroleum prices.

    – Analysts ignore energy, the same analysts overlook the ongoing credit embargo taking place in the EU. There is no economic reason why Spanish rates must rise. The blame is fixed on ‘investor confidence’ when Spain has the same debts now it had this time last year. The European countries have less aggregate debt than does Japan. What the EU lacks is exchange-rate flexibility within itself (see that impossible trinity again …)

    Taking place in Europe and the rest of the world is conservation by other means, the world is becoming car-free. If humans aren’t careful, if they stop acting like children and start jettisoning the luxuries the world will become human-free.

    Get with it, folks, you’ve all got children. What sort of world are they going to inherit? A wasteland?

  6. bold'un

    Replying / adding to Steve
    The problematic rule is surely the mismatch between the ECB’s estimation that Euro sovereigns are risk-free and the reality that they are full of risk. What the ECB needs to do is to risk-weight all Eurosovereigns (including Bunds) in a sense limiting all euro-banks’ exposure to their base sovereign credit. LTRO operations are fine if and only if the money goes to fund trade rather than being a backdoor funding for governments in trouble.
    Another problematic rule is that Forex forward rates and interest rate differentials are linked. But right now Forex forwards are based on theoretical rather than real interest rate differentials which harms the economies of weaker states. So a Greek exporter should pay more to borrow but benefit from a weaker forward exchange rate than a German exporter. Right now he gets the former but not the latter!

  7. PG

    With sovereigns shut out of global markets, the problem is that they now suck up all “local” capital leaving absolutely nothing left to the retail market.

    The result is the retail market having to may more than the sovereign.

    I suppose to the solution would be the ECB lending directly to the sovereigns, so the banks can go back to retail.

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