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Saturday, 10 December 2016

Follow the Money (2)

The best way to look at money is by comparing it to your house and to your mortgage. Both are "money" but a house is an asset and a mortgage is a loan. Money has four dimensions: Quantity (eg, m2/m3), Quality (eg, location), Price (eg, Euros) - or combined: Value - and Time.

The dimension Time has a different impact on the Value of an asset and a mortgage loan. Initially, the asset and the mortgage loan are equal in Value (= 100% mortgage). The future (sales) Value of a house may go up or down. The Value of a (interest only) mortgage loan does not change but Time does affect future interest rates (= price) which go up or down (floating interest) or remain stable (fixed interest). The resulting difference in Value is called (negative) home equity. Note: mortgage redemptions do not create wealth as Cash (= assets) is paid to decrease the loan.

The price of houses is determined in the residential markets, and the price of mortgage loans in the financial markets, both by demand and supply. If customer demand remains the same then decreased/increased supply will cause price fluctuations in both markets.

Since early 2015, the ECB has been creating a monthly amount of 80 billion euro of new money to stimulate the European economies. This new money follows 3 scenarios: (1) economic growth (= ECB's intention), (2) inflation (asset prices and/or monetary), and (3) interest rate declines.

It's hard to quantify these 3 scenarios individually. It's likely that all 3 have happened simultaneously. In the Backlight TV episode of 27 November 2016, ECB Chief Economist Peter Praet defends the ECB quantitative easing program but agrees that asset price inflation caused an increase in wealth inequality: see video > 41 minutes. In the ECB's view, EU member states are responsible for fixing this collateral damage through their fiscal policies. 

The video gives a perfect example of an increase in wealth inequality due to asset price inflation: a 30 year existing government bond yielding only 1.7% interest had a 30% return within 11 months as a result of excessive ECB government bond purchases (video > 18 minutes). 

No doubt, ECB President Draghi will continue claiming that European economies would have been in a worse shape without his excessive quantitative easing of some 1.5 trillion euro. We will never know. What we do know is that this program is like giving free drugs to an addict. Why would you rebalance your national economy - and risk losing voters - in case of free money? 

To some extent, something similar happened in the EU's monetary union. Before, weak European countries borrowed money in national currencies at high interest rates (eg, Greece, Italy). Afterwards, these countries borrowed in Euros at a lower "average" of all EU member states. The resulting discount for weak European countries was basically a "calculated risk" that Europe would bail out its future failing member states as these were "too big to fail".

Some 15 years ago, someone taught me a wise lesson: in case of debt, it's always better to have large debt rather than small debt. Creditors are only interested in finding repayment solutions in case of large debt. Greece is a good example of this concept as Germany and France (ie, their banks) are still looking for solutions to prevent massive debt write-offs

The ECB has put a new time bomb in our financial system (eg, UBS chairman in FT).

The Gap Band - You dropped a bomb on me (1982) - artists, lyrics, video, Wiki-1, Wiki-2