Mario Draghi has now committed the European Central Bank to buying at least 60 billion euros worth of government bonds, that is those bonds issued by the various countries that make up the European Union. This is a monetary policy also known as Quantitative Easing. The idea is that by buying bonds on the open market the central bank will inject liquidity or money into the various country economies in particular and the general EU economy in general. The EU itself does not issue bonds. So what happens as the ECB crowds out the private sector investors such as individuals, brokerage houses, hedge funds, and banks? Investment money follows return. In investing, one can lend or buy high yield investment vehicles such as corporate bonds, government bonds, high tech stocks, and so forth. But high yield comes with high risk. If your credit score isn’t in he 800’s you will pay higher interest rate, pure and simple. And a higher interest rate means that you may have trouble paying the interest and may eventually default on the principle. In the world of government and corporate finance, one doesn’t pay down the amount borrowed, one merely pays the interest due each quarterly, semiannually, or annually. The principle is a balloon payment, due on maturity. Now some governments and corporations simply roll over the principle when it comes dues and keep paying the accumulated interest. Others entities set aside money in a sinking fund or similar account so that the funds accumulate over time and when the maturity date arrives the funds are there to pay back the principle. This is a very good and sound practice for it assures that debt remains real and not fantasized as never ending.
But if the central bank is buying these securities, then how does that affect the economy? The Federal Reserve Bank started doing this back in 2008 by buying some of the U.S. Treasury bonds. That means that all those interest payments come back to the Treasury less the Fed’s expenses. But the Fed doesn’t really have any money per se. It simply created the credits with which to buy the bonds. That meant that those firms and individuals who wished to purchase bonds would soon need to put their money elsewhere. This is the case of Japan where its central bank has been buying nearly all of the Japanese government bonds and is now buying private securities as well. Let us say that you are a young man with a job and you decide to buy a few bonds each year, Maybe you favor 30 year bond maturities when you are young so that as you approach retirement you will have some security for your old age. But now the BOJ has crowded you out of that bond market. And besides, it also lowered interest rates it controls with banks. Now the Banks won’t pay you four percent on a savings account and you are lucky to see a quarter percent of interest each year. Your savings are not going to grow much at that rate and if inflation, that concept that economists believe is needed for economic growth, then you are actually losing money. That is, with inflation at one percent your money is actually worth less because its growth rate is far below that of the rate of inflation. It is the difference between real income and nominal income. So now you must cast around and find some investment vehicle that pays a higher return, something like at least two percent and more if possible. But since there are many more of you looking for higher rates of return in markets where the risk is higher that means that your rate of return versus the interest rate may be lower. If you want corporate bonds that pay four percent you will pay a premium for them, meaning that for every $1000 face value amount of bond you buy you may have to pay a premium of four to ten dollars per thousand face amount. That cuts your yield to less than four percent. And if one is willing to lend at a higher interest rate then one should expect greater risk that the face amount will not be paid back. Or that bond could be redeemed early if interest rates are driven down even flatter.
What happens is the the monetary policy of Quantitative Easing interferes with investment and causes inflation in the sense of competition for investment funds. Yes, more investors have more money to invest in high risk investments but that means that capital improvements are at risk. Why would that be? Because the corporations find that it is easier to make a quick profit from speculation than it is through capital investment. If my company is rated Triple AAA then I can borrow at lower interest rates and command a premium from the lender who would other wise have to take more risk. But if demand for my product is not increasing then why would I want to invest in capital improvements? I will need that increase in revenues and profits to pay for the improvements through loans against my capital. Money only became cheap when GDP bottomed out, when there is no economic growth or expansion. What we have is investment money chasing high returns on investment and not corporations expanding employment and purchasing raw materials. The retailers are not expanding inventories and raising prices in this type of inflation. No, the inflation is one of yield and rate of return, assets are inflated. Usually raw materials such a copper, iron ore, coal, and the like start rising because of the anticipation of economic activity. the the speculation sets in and prices rise until there is no greater fool left to buy. Then all the greater fools start selling off and prices collapse.
Quantitative Easing starts money chasing money and that is where the inflation flows. The price of luxury homes inflate beyond belief until they don’t. We had asset bubble forming for the last thirty years and many of them have or are now in the process of bursting. That means that economic activity starts to become stiffed as the economy recedes or even collapses. Then the money starts to be poured into the economy, not in the form of investment that employs people to make stuff or provide services, but as money chasing money. Speculation is encourage and investment is discouraged. That is really the size of it. An economy can only grow through a growth in employment and a growth in employment only comes with an increase in consumption. If consumption is fueled by credit then there will come a time when that expansion cannot continue because people have run out of both stuff to buy and money to buy it with. And if there are no investment opportunities because people cannot buy any more goods and services and are having a hard time paying for what they bought in the past on credit, then the only game left in town is speculation. It is that simple. Now you tell me why the likes of Nobel Prize winners like Paul Krugman can’t see that development. Are almost all of our modern economists really that stupid? A man will believe what he gets paid to believe.
So where will the EU go? Into bankruptcy just as the Japanese are there now but just don’t recognize it and we are right behind them. The Federal Reserve has well over one trillion dollars of Treasury Bonds, Mortgage Backed Securities (bought from banks using repurchase agreements, meaning that the banks are suppose to buy them back at the price the Fed paid) that are full of non performing loans, and corporate bonds and shares of stock. What happens when interest rates are forced to rise? The whole system goes bust. Oh, that doesn’t really affect those financial instruments being held right now, it affects the ability to borrow in the future are rates that an entity can afford the interest payments. It also reduces the values of those financial instruments being held now. That 30 year bond with a coupon rate of 2.25 percent, it will still pay 2.25 percent per year. But if the Treasury has to issue new 30 year bonds at 4 percent guess what the value of that bond becomes? Far less than the $1000 par value. Investment is based on the value of a dollar in the future. I may be willing to lend you a dollar today and accept a dollar in repayment tomorrow. But what a bout a week from now, or a year from now? I think I want to be repaid more than just a dollar. And if I’ve got to wait twenty more years for repayment of that face amount but the interest or coupon rate is far below what everyone else is willing to pay, then I will not pay the face amount for that bond, I will extract a discount, that is, that twenty year wait means that part of that face value is the difference between the interest I collect each year and the total interest I would have collected for twenty years. I will offer to buy that bond for less in order to realize my income over time. This is what it is about.
So, to reap. We have pigged out on credit and can’t get any more. We have problems paying back what we owe and may even default on some or all of it. There is no net creation of new jobs and thus no increase in the goods and services being consumed. When the future comes when we have either repaid our credit or defaulted on it and we can now afford to consume more goods and services hen real interest rates will rise for capital that goes to increase capital investment for the production of more goods and services. That is how economies work. You can only financially engineer recessions and depressions. We cannot spend our way to wealth. Can’t be done, no way, no how.