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Thursday, February 06, 2014 10:08 AM


Monetarists Accuse ECB of "Dangerous Game of Chicken"; The REAL Dangerous Game


This morning, ECB president Mario Draghi Held Rates at 0.25%, while rejecting fears of deflation.

ECB president Mario Draghi said: "We have to dispense with this idea of deflation. The question is - is there deflation? The answer is no."

Eurozone inflation slowed to 0.7% in January from 0.8% in December.

In addition to holding its benchmark rate at 0.25%, the ECB also left the rate it pays on bank deposits unchanged at zero.

At a press conference to explain the ECB's latest decision, Mr Draghi said: "There is going to be a low level of inflation for a protracted period of time, but deflation? No.

"The modest recovery is showing encouraging signs. The demand side is getting stronger, not weaker. We have to treat the recovery with extreme caution. It is very fragile. It is starting from very low levels but it is proceeding."
"Dangerous Game of Chicken"

It did not take long for monetarists to respond. Ambrose Evans-Pritchard quickly whined "Insular ECB is playing dangerous game of chicken with deflationary world forces".
The US and China are withdrawing stimulus on purpose. The eurozone is doing so by accident, letting market forces drain liquidity from the financial system for month after month.

The balance sheet of the European Central Bank has fallen by €553bn over the past year as banks repay money that they no longer want, either because ECB funds are too costly in a near-deflationary world or because lenders are being compelled by regulators to shrink their books.

This is "passive tightening" or "endogenous tapering". The ECB balance sheet has plummeted to 23pc of eurozone GDP from a peak of 32pc in July 2012.

Hardliners will be delighted to learn that we now have synchronized G3 global tightening at last, further compounded by enforced tightening in Brazil, India, Turkey, South Africa and a string of emerging market states trying to defend their currencies. At least two-thirds of the global economy is turning down the liquidity spigot.

Retail sales fell 1.6pc in December, the biggest drop for two-and-a-half years. The unemployment rate has stabilised at 12pc, but only because so many people have dropped off the rolls or fled abroad. Italy has lost a further 425,000 jobs over the past year.

Euroland is sliding further into Japanese deflation trap every month, whatever they claim in Frankfurt. Passive tightening has caused private sector loans to fall by €155bn over the past quarter. "The ECB's insistence on waiting for more evidence of deflation is a dangerous gamble. Delays are costly, and risk allowing pathologies to fester," said Ashoka Mody, until recently the International Monetary Fund's Troika firefighter in Ireland and now a contributor to Bruegel.

"The ECB should be picking up the baton of quantitative easing from the Fed instead of sitting on its hands. They have presided over tight monetary policy for so long that they have let an intense deflation risk take hold," said Andrew Roberts, credit chief at RBS.

Peter Bofinger, one of Germany's five "Wise Men" and a critic of the Bundesbank foot-dragging, said the ECB should launch "far-reaching bond purchases" immediately to head off the danger of deflation, deeming any other measure to be a drop in the bucket at this stage.

The ECB's tight policy has led to the surreal situation where the world's weakest economy - barely out of a deep recession - has the strongest currency. This dynamic is all too familiar to anybody who remembers what happened to Japan. "The greatest danger for the eurozone recovery is a further rise in the euro. They must avoid a rise to $1.40 at all costs," said Mr Bofinger.
So Much Nonsense From So Many People

Seldom do you find so much nonsense, from so many people, all in one place.

The notion of passive tightening is ridiculous. Retail sales did not decline because of passive tightening. Banks refusal to lend is not passive tightening.

Banks returned money to the ECB for one of two reasons:

  1. Banks are capital impaired and cannot lend
  2. Banks have no creditworthy borrowers who want loans

Yes, it is that simple. So how the hell will QE fix that? The answer should be obvious: it won't and it can't.

The second ridiculous notion in the articles is "Five Wise Men" in Germany can plan the European economy. Central planning everywhere is a miserable failure but people who don't understand history want more of it.

Supposedly, the ECB must "avoid a rise to $1.40 at all costs." And of course the US must avoid a rise in the dollar, and Japan must avoid a rise in the Yen.

Meanwhile, consumers everywhere want lower prices.

The REAL Dangerous Game

The idea that deflation needs to be fought is preposterous. everyone benefits from falling consumer prices.

The fear should not be of falling prices, but rather of bursting asset bubbles. The economic demise we are in today stems from debt-deleveraging following the bursting of asset bubbles.

And it is monetarist and Keynesian stimulus that fosters asset bubbles. We have huge asset bubbles right now. Those bubbles will burst regardless of what non-wise men want.

The sooner those bubbles burst, the better off everyone would be. Certainly we would have been better off had the housing bubble burst in 2003 rather than 2005. But monetarists like Greenspan and Bernanke wanted to keep the artificial boom going. And so they did, with extremely damaging consequences.

Pritchard now leads the way with reckless monetarist calls even though the demise we see today is from the very monetarist policies he espouses.

Prevention is Paramount

The only way to prevent asset bubbles from bursting is to not foster them in the first place.

I assure you it's far too late for that. Just like 2007, very few people even recognize bubbles even exist. And many of those who do recognize the bubbles are willingly playing the greater fool's game expecting they will be able to get out of the way when the bubbles pop.

It seldom works that way. Those riding bubbles seldom spot the top. More often, they become true believers themselves.

Final Thoughts:

It's not falling prices central banks should fear, but rather asset bubbles. The irony is central bank actions to prevent falling prices are the very thing that creates asset bubbles! When to pull the punchbowl is "real" game of chicken in play (and central bankers never get it right).

Additional Reading

For more on bubble-sponsoring mentality, please see What the Crisis Taught Us: More Bubbles! We Need Bigger Bubbles to Combat Deflation!

For discussion on what causes bubbles, please see Bubblicious Questions: What Causes Economic Bubbles? When Do Bubbles Burst? Can the Fed Prevent Bubbles?

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com

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