To understand why interest rates are artificial one needs to consider the following. On the October summit, the European Council agreed to raise the capital requirements each private bank needs to comply with by June 30, 2012. In practice policy-makers agreed to ask from banks to raise huge amounts of fresh capital in order to fill in the gap between what they actually possess and what is now required from them. The criteria are about the part of the capital which is considered Core Tier 1. Government bonds are considered by regulators as one of the main constituent of that particular type of capital. In practical terms these new criteria ask from banks to buy government bonds in order to pass the test, as no other effective way exists of raising fresh capital from the market, as recession and uncertainty do not allow for such course of action, at least not large-scale.
The problem with all this is that back in October banks did not possess enough money to buy the amounts of sovereign bonds they are in need of, simply because the ECB was at the time much tighter with the money supply than it is today. A few weeks ago this monetary policy changed, as the ECB decided to first lower the primary interest rate and next initiate its LTRO programme, which is a package of cheap 3-year loans to private banks, with the ostensible purpose of injecting liquidity in the real economy. Of course bankers have absolutely no reason to supply that extra money to the economy since they first fear that the ongoing recession will potentially be costly; and second they are in desperate need of Core Tier 1 capital, which means that they need to buy government bonds.
In effect banks face the dilemma of either going bankrupt or buying sovereign bonds to continue their existence. Now what kind of bonds would a banker prefer given the existing conditions? Of course the one which on one hand will yield a sufficient premium over the German bonds that pay close to 0~1%, while on the other hand will not be subject to any type of debt restructuring/"haircut" in the near future, at least not before June 30, when the capital requirement deadline expires. There are two countries whose bonds satisfy these demands: Italy and Spain. On one hand they pay a quite high interest rate, on the other they will not come to the need of a bailout within the next few months unless something extraordinary happens.
Anyone willing to board that train of thought realizes that policy-makers have narrowed down the available options and have provided all those incentives which make banks buy the sovereign bonds of Italy and Spain. As bond buyers (European banks) increase, interest rates fall. Banks are happy because they can now use those bonds as collateral to receive more loans from the ECB, or as Core Tier 1 capital to pass the capital requirement criteria with flying colors, while Italy and Spain also seem satisfied since their interest rates have fallen.
In parallel to all the above one needs to bear in mind that the ECB has never stopped buying Italian and Spanish bonds, already pushing interest rates downwards.
So far it seems that policy-makers have been smart enough to succeed in reducing interest rates, thus easing the pressures on Italy and Spain, the eurozone's 3rd and 4rd largest economies. One may call this a very rational plan. In truth it is not, for one has to consider the impact of all this cycle in the real economy.
The real economy is falling into a recession as consumers buy less, entrepreneurs cut back investments, people lose their jobs and banks are very restrictive with the loans they give out. In short the real economy is losing economic activity, while liquidity is being steadily reduced. To provide a backstop to this recession, one of the requirements would be to ease liquidity in the market, i.e. banks to issue loans, so that investment and consumption may again be stimulated. But as mentioned above banks have no incentive to do so, since the opportunity cost would be quite high as they would not be able to buy those much-needed sovereign bonds they are in desperate need of.
As such the real economy will continue to remain stagnant or in a state of contraction while the bond auctions will continue to create the misleading impression that confidence in the system is restored. In truth the real economy loses a lot out of this interplay between banks, regulators and states, which translates into reduced real income as revenues fall, reduced wages as unemployment rises, and reduced real purchasing power as taxes will rise to cover this additional debt, while inflation will kick in over the medium term.
What is now happening is purely artificial. Markets have not regained confidence in the euro nor in its constituent states, while the real economy is not expanding to produce real savings and real investments, which are the only means of leading to robust growth that will ensure the end of the crisis. All that is now happening is that banks are in the artificial need to buy sovereign bonds; hence they rush to do so, pushing interest rates down. This cycle of "thin air", initiated by the ECB who has lately been printing money like a drunken sailor, will not be enough to stem the tide. Only real growth, away from supercomputers and the exchange of digits of fiat money, will bring confidence back in the eurozone. Needless to say that all this is a clear sign of malinvestment that distorts the capital structure, but in today's eurozone who can possibly care about that?
Article source: http://www.protesilaos.com/2012/01/real-effects-of-artificially-low.html
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