Erwan MAHÉ 00 33 1 53 05 57 Allocation d'Actifs et Stratégies d'Options

Isegoria Rules!

The Euro, a false Modern Money?

A few economists like Wynne Godley, L.Randall Wray, Warren Mosler, and Stephanie Bell had clearly predicted the procyclical, deflationist and self-defeating nature of the institutional arrangements of the common currency. After taking a hard look at the mechanisms regulating the relationship between the new monetary body (the ECB) and fiscal authorities (the national governments), they concluded that a single narrow liquidity crisis would evolve into a sequence of wildfires, engulfing banking systems and the weakest sovereign debts.

It seems we are now in the midst of the real thing…

The Eurozone financial system is completely dysfunctional - Banks don’t lend to each other anymore, except the largest ones and mostly on a national basis. - Counterparty risk (balance sheet) has been compounded by sovereign risk. Itraxx Europe Senior Financial Index/ 5 years

When money does not circulate between banks, money is not created, since “loans create deposits”. The ECB is trying to fix this problem with its new intermediation role.

The ECB is the new money market - A large part of the banking system has lost access to the interbank lending market and turns to the ECB

Main Refi, MRO & LTRO amounts outstanding

- The ECB plays a new role of intermediation as banks with excess reserves stash their cash at the central bank

Banks deposits and current account at the ECB

But a few problems subsist: - The ECB asks for collateral whereas interbank markets involved unsecured lending. The ultimate step would then be to accept any loans as worthy collateral, and that is the process we have been seeing with easier and easier collateral rules. Qualitatively and quantitatively.

- The spread between deposit and refi rates is now a tax from north to south, but should there be any, if the ECB were to just fulfill its public function?

The ECB is also easing - The ECB also recently tried to ease its ‘monetary’ policy stance, in order to comply to the ‘fiscal austerity – easy money’ policy mix.

Short term history of soft core spreads

Beyond the help its VLTRO gave to peripherical banks, the ECB lowered all of its three policy rates, responding to a clear reaction function. The 2 Year synthetic euro bond Yield and the policy corridor

A modern central bank does not target the ‘quantity of money’; velocity of credit is too unstable. It only tries to influence the aggregate demand by manipulating the interest rates level, along the yield curve. But that also affects the currency!

These interest moves also explain the recent weakness of the common currency

3 months Euribor and Libor, 2 Y Tnotes and Schatz

But this one size fits all policy leaves some massive divergences in place!

When a sovereign is considered at risk, monetary policy seems impotent Any intervention by the ECB on the contrary now exacerbates the problems, given the infamous Greek PSI. And the ECB seems to consider a bail-in of senior bank bond holders now? With a preferred status for the ECB LTRO I suppose.. Italian, Spain and Germany 10 Y bonds Yields

Only a ‘shock and awe’ strategy, like that implemented by the FED in March 2009, or by the SNB with its currency ‘ceiling’, would now enable the Eurozone to get out of this mess. The European people will never endure years of ‘internal devaluation’; there is no such democratic for such a harsh policy. The only second best choice would then be for Germany itself to leave the Eurozone…