"Eurozone monetary transmission broken'

It is now official: The Eurozone’s monetary transmission system is broken

Yanis Varoufakis

Yanis Varoufakis,

17 July, 2012

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 p[aid 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