The President of the German Savings Bank Association Georg Fahrenschon just submitted ‘a disastrous balance sheet’ to the European Central Bank (see here) and the German Finance Minister made his Parliamentary Secretary Jens Spahn declare that ‘Cheap money alone does not lead to more growth’ and that ‘we also need structural reforms.’ These structural reforms are of the type that Germany already implemented. It is as simple as that. It suffices to throw the magical words ‘structural reforms’ into the room and all of sudden even Germany is off the hook. We have often shown that it is not that simple. Today, I will try to explain this by using the banking crisis as an example.

In order to understand the European banking crisis, it is necessary to look in some detail into the ways in which a normal bank produces profit. Traditionally, the core of the banking business is described by the transformation of money available at a short term is transformed into long-term credit. Profitable banking consists of placing long-term loans and to fund them in the short term. The bank’s profitability, in this view, is determined by the difference between the short-term interest rate and the long-term interest rate.

As we have shown in some of our contributions of the last few weeks, the concrete task of banks consists of lending where long-term interests are being charged. In order to fulfill this role, neither deposits of savers nor the availability of central bank money are crucial. However, banks are responsible for the settlement of payments of virtually all economic actors. For this, they usually need central bank money. They borrow this money from the central bank and are being charged the short-term interest rate. In this view, it is also the difference between the interest on long-term loans and the interest on short-term central bank loans that determines the profitability of the banks.

The fact that most of the transactions of banks do not take place in ‘lockstep’ (cash inflows and outflows) determines the volume of liquidity (central bank money) that is necessary for the banking system as a whole and for each individual bank to sort out payments. If everybody would have an account with the same bank, the lockstep would be normal and there would no shortages in payments which need to be financed with central bank money. In reality this is of course not the case and therefore the banks need liquidity. This capital is being provided by the central bank. The banks are charged a specific interest for this. The same rate applies in businesses between banks in the money market.

The most normal of all banking transactions in today’s system is banks providing credit to a state. States are being refinanced through the capital market. The government sells the bank tradable debt securities (which are commonly called Bonds) on the capital market. The government pays on the bonds, say ten-year government bonds, a certain interest rate, which is usually called the basic long-term interest rate (the interest rate on ten-year government bonds constitutes in fact in almost all developed countries the benchmark rate upon which all other interests are based). This long-term interest rate is of course is not completely independent from the formation of the short-term interest rate by the central bank. Various substitutions between the two exist (for example long-term financing is replaced by shorter term financing when the two interest rates are very far apart). Since the long-term interest rate is usually determined by auction and keeping the above restrictions in mind, one can say that the long-term interest rate is a price that originates in a market.

Normal banking business is only profitable when the short-term interest rate is below the long-term interest rate (I use common parlance here, using interest and interest rate interchangeable, although this is not entirely correct. Interest corresponds to the result of the multiplication of the loan amount with the interest rate minus the loan amount). In normal conditions the short-term interest rate is lower than the long-term interest rate. One says that the structure of interest rates or the yield structure is positive and normal when the margin for the banks is positive. (The interest structure refers to the difference between the long-term and the short-term interest rate).

There are however also times when the short-term interest rate exceeds the long-term interest rate. This is called an inverted yield structure or inverted yield curve. In the past, the phases of an inverted yield curves were mostly short. Usually they were triggered by deliberate restriction policies of central banks to combat inflation. Normal banking business was never compromised. But now this has changed.

Let’s look at the interest rates and the interest structure in some important countries during the last 25 years. First, we consider short-term rates (figure 1). We show the evolution of the interest rate for three European countries, both before and after the launch of the euro. After the global financial crisis of 2008/2009, both the US and Europe followed Japan’s evolution towards zero interest rates. Since 2012, all three major economic regions attempted by monetary policy means (zero interest rates) to avoid deflation and stimulate their economy.

Figure 1

In principle, long-term interest rates follow short-term interest rates (see figure 2). All the countries under consideration recorded a sharp decline in long-term interest rates after the transition of the central banks to zero interest rate policies. However, the latest values (we ​​used those from mid-February to represent 2016 in the chart) show extreme results. Rates in Germany, Japan (and Switzerland) are either zero or negative.

Figure 2

The consequences of this for the interest rate structure are enormous (see figure 3). On closer inspection and keeping the phases of economic development in mind, it can be seen that the yield curve appears to be significantly related to the degree of overall economic development as well as to evolution of economic cycles. Remarkably, inverted yield curve phases precede the occurrence of recessions or downturns. The data on the US show this the best. In the years immediately before and after 2000, the interest structure inverted and a recession quickly followed (the end of the so-called dot.com bubble). The yield curve in the US and in Europe inverted also before the outbreak of the global financial crisis of 2008-2009.

Figure 3

The interest yield also inverted in 1992 and 1993 in Germany and in France. Again, a recession followed afterwards. Conversely, if the central bank tries to stimulate the economy with low short-term interest rates – as during the global recession in 2008 – the yield rapidly moves into positive territory. The mechanism behind this is easy to understand. Lending becomes unprofitable for the banks when the yield inverses, because the margin described above threatens to slip into negative territory. Consequently, they have to restrict lending, with the result that the economy slides into recession.

The contrary happens when the margin is positive. Then banks are eager to lend. But the eagerness of the banks is a necessary condition but not a sufficient condition for growth. All we need for a real upswing to take place is that there are reasonable demand conditions such as positive income expectations for the majority of the population (a point we often emphasise). If demand is expanding and companies begin to demand credit then the central banks and the commercial banks have to release the brake on the credit machine (this expression comes from Joseph Alois Schumpeter who spoke in relation to the gold standard of the ‘golden brake on the credit machine’).

Until now, the interest rate policies of central banks have been sufficiently robust to solve such problems. Central banks have proven on several occasions that they can be strong in a restrictive direction. But central banks have never been strong in the opposite direction, the one towards expansion. Often enough this was not a major problem, because demand was sufficiently strong to make the machine run at full speed again when the brakes were being released. But these days, the situation is quite different. Now we are going through deflationary times. The interest structure curve has been moving towards zero since the beginning of this year. The rate is negative in Japan and in Switzerland. In Germany, the long-term interest rate is only slightly above zero. This means that, at a time when the economic development in Germany and Europe as a whole is very weak and investments are urgently needed, banks systematically lose the incentive to lend because there is nothing for them to earn. This is a completely new and atypical inversion.

Obviously, the ECB has managed, through its purchases of long-term securities (in which government bonds are quantitatively very important) of some countries, to lower long-term interest rates. This is especially true for the creditor countries of the North. This should increase the incentive to invest. However, at the same time, the ECB put the banks in a very difficult position. The profit margin of the banks almost disappeared – if one reckons with the fact that the banks have to pay penalty interests for liquidity that remains at the central bank, the profit margin is perhaps completely gone. I cannot tell you offhand which of these two effects is the strongest. One must also bear in mind that when the interest yield inverses, rising short-term interest rates usually increase long-term interest rates, so that both effects evolve in the same restrictive direction. There is no doubt that the policy of the ECB contributes to the problems within the banking sector. It may even be the most significant factor.

Compared to a normal inversion, the time frame is also extremely problematic. A typical cyclical restriction phase usually lasts only for a few quarters. No one can predict how long the current phase will last.     Several years of such an atypical inversion turn into an existential problem for large parts of the banking sector as a whole. Not only big banks, but also smaller banks, such as for example the German Sparkasse are suffering great losses.

Another negative side effect of the policy of the ECB is that the effect of the ECB’s policy on national interest rates is not clear. Portugal fell already prey to speculation: the interest on 10 – year government bonds was raised to over four percent because considerable uncertainty exists in the financial markets about the country’s economic development. Since the ECB has no clear objective with regards to the impact of their interventions on national interest rates, it does nothing to prevent such new spreads. Consequently, at least for as long as there are no euro bonds, at the minimum, the ECB should intervene, so that long-term interests fall in all countries at the same pace.

Europe is now being confronted with a situation that cannot be called anything else than a deflationary banking crisis. This is not just a consequence of the misguided regulations and policies of the ECB, as many suspect. It is primarily the result of weak demand, which has been mainly caused by the wage moderation in the developed world and particularly in Europe. In Europe, positive income expectations for most of the workers have been largely destroyed. The negative consequences of wage moderation have been further amplified by harmful financial and economic policies. Instead of implementing policies to stabilise and increase demand, the state withdrew and concentrated upon delivering ‘stable state finances’ à la Swabian housewife. This only increased the weakness of demand even further.

This means that the drive of the credit machine has been removed. No ‘structural reform’ can change this. The ECB will ever so often take the foot off the brake: it does no longer help. The extreme easing experiments of the type that have been described here involve the risk of causing damage to the credit machine itself. These dysfunctions will show up one day, when demand increases again and the machine needs to function properly.