Europe: Spreading the Pain

May 15th, 2013
in Op Ed, syndication

Terminal Velocity, Part 8

by Adam Whitehead,

Like his former MIT colleague Stanley Fischer, Mario Draghi hinted that their former MIT colleague's "Helicopter" will soon be taking off, in his most recent ECB press conference; but was quick to opine that it won't be flying in Europe[i]. In doing so, he provided more support to the thesis in Terminal Velocity (4)[ii], that "the Eurozone, faced with the prospect of break-up, as the Germans refuse to pick up the tab for fiscal union without a global bank run, provides the lowest fruit on the tree to be picked this summer". Draghi has gone even further than Fischer, by creating the necessary conditions for a fully blown European bank run. He has created these conditions by going one better than Bernanke and moving beyond the "Zero Bound"; to the "Negative Bound", where lenders and depositors pay financial institutions to take their money[iii]. The thought of paying a shaky European bank to take one's deposits, after what happened to depositors in Cyprus, apparently seems like a reasonable quid pro quo to "Super Mario".

Follow up:

Negative interest rates on reserves will allegedly fix the broken transmission mechanism. The commercial banks will take money out of the ECB, because they are paying to keep it there; and will allegedly lend to each other and the private sector. It all sounds plausible.

What is probable however?

Commercial banks will all drop their own deposit rates to negative levels. There will therefore be no reason for them to lend to each other. The interbank funding market therefore gets even worse.

Depositors take money out of their banks because it is not earning interest. A bank run will then occur.

There will thus be a run on the already weakened European banking system. Presumably the money will go into Gold; and also the US Dollar where interest is still paid on bank deposits and reserves at the Fed. There will thus be a run on the Euro also. The run on the Euro may seem like a good thing, because it will boost European exports; but in a slowing global economy, where every central bank is playing the currency war game, it's unlikely to work.

There is also a real problem with inflation. When the Euros are in the banking system, they can't create inflation. When they are out of the country, in American banks for example, similarly they can't create inflation. The problem is that Foreign holders of Euros will dump them as fast they can, since holding them in banks actually costs money. The Euros will therefore end up back where they started in Europe, chasing goods and services that are becoming scarcer as the European economy becomes weaker. The devaluation of the Euro will thus create serious inflation. If Draghi is lucky the Euros will be used to finance Sovereign bond issuance, so they will not be unleashed on the real economy. Freezing them in the Sovereign bond market however, just returns Europe to the current status quo of a broken transmission mechanism. So what's his point?

Presumably long before all this occurs, the Germans will have cried "Weimar" and left the ECB building. The Euros will be chasing Bunds; if Bunds are priced in Euros that is.

It's hard to imagine that Draghi has not thought all this through, so we can only believe that he has decided to hit the game-over button deliberately. To rebuild Europe, it must first be destroyed. The ECB has been attempting to destroy it financially, by forcing through bank resolution legislation at the national level. This legislation would enforce "Bail Ins" at the national level, not the Eurozone level. This would then cause the restructuring of European finance and industry that the Germans and also the ECB would like to see. European national governments, especially in Italy and France, do not want this to happen so they have pushed back[iv]. Draghi has therefore announced the nuclear option of negative interest rates, which will do the job indiscriminately instead. The bank run that follows, will force the European banks to restructure their portfolios, which will have a similar knock on effect in European industry and commerce.

Two birds get killed with one stone. The European crisis launches Bernanke's Helicopter and Europe finally starts its long overdue restructuring phase.

The next bank run in Europe will be far more insidious, because it will start to strip away weaker members of the Core from Germany. Up until this point, Core Taxpayers have been shielded from paying for "Bailouts", even though they have a perverse belief that they have been paying all along. The "Bail Ins" so far, have come at the expense of lenders, depositors and Domestic Taxpayers. This is all about to change; and when it does, those members of the Core who are being stripped away are in for a shock. The Peripherals, who had to endure "Bail Ins" will demand that the newly poor former Core members must do the same. Remaining Core Taxpayers will also enforce strict "Bail In" rules. This is why Italy and France have joined forces to rewrite the Solidarity Pact, to make sure that they don't have to endure a "Bail In". This is also why we think Draghi just went on the negative interest rate counter-offensive against them.

Click to enlarge

It looks very much like the Netherlands will be the canary in the Ruhr coal mine, which suddenly shows that Core can become "Bailed In" Peripheral in a heartbeat. The Netherlands today resembles where Greece was two years ago. All of a sudden, the threat of a Core country defaulting on loans and deposits is very real. If the Netherlands goes, then Spain and Italy (and also France) have an easy excuse for following the Greek approach of walking away from their debts. Mario Draghi has however prompted the depositors and lenders to walk away from them first, with the same result for these countries but a lucky escape for the depositors and lenders. Draghi is thinking globally and acting locally, in order to prevent the contagion from spreading out from the Eurozone. The European bank run will therefore be terminal for Europe, but not so for the global economy.


[i] Chopper Envy: Mario Draghi Bashes "Helicopter Money"

[ii]Terminal Velocity (4) – “Bernanke’s Helicopter Landing At Jackson Hole”

[iii] Draghi Mulls Negative Campaign as Economy Struggles

[iv] ECB Bid for Fast Start to Bank Loss Rule Blocked by Nations

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