Will the European 'QE' Make It to the Finish Line?

April 28 2015

In 1971, the (semi-)gold standard was abandoned and replaced by a PhD standard. Under the PhD standard, the money supply is no longer linked to the national gold reserves, but is instead at the mercy of central bankers and their arbitrary judgments. Never before did academics have so much power and influence over the financial markets.

Will the European 'QE' Make It to the Finish Line?

In 1971, the (semi-)gold standard was abandoned and replaced by a PhD standard. Under the PhD standard, the money supply is no longer linked to the national gold reserves, but is instead at the mercy of central bankers and their arbitrary judgments. Never before did academics have so much power and influence over the financial markets. However, we may very well be nearing "peak central banking." Due to the astonishing course of events that I will discuss in this article, the European Central Bank may very well become the protagonist of this chapter in monetary history. Why? Because Mario Draghi’s QE — a program that promises to buy €1,140 billion worth of government bonds each month — could end prematurely. And not due to a conscious decision made by Draghi, but because the limits of monetary policy will become painfully visible. So what about the European QE? And why will Draghi get in trouble?

The Limits of Central Banking

In reality, central banks do not have many tools at their disposal. The only tool that central bankers have is the power to create money, and to buy with it whatever they please. But in order for them to do that, governments had to grant central banks the monopoly of money creation.

When the Federal Reserve was founded in 1913, the general consensus was that central banks should limit their purchases to 'real bills.' These are short-term commercial credits, backed by actual goods. After 1945, this limitation to 'real bills' was abandoned and central banks started buying short-term treasury bonds in order to lower interest rates to levels they considered desirable. After 2008, buying long-term treasury bonds had become the standard ('quantitative easing'). As of today, central banks are prepared to buy any asset, including mortgage-backed assets and even stocks.

Of course, the most fundamental limit on central banking is a general loss of confidence in the currency. When the public believes that the central bank will continuously lower the value of the currency, they will be inclined to exchange their cash holdings for hard assets. This can lead to hyperinflation and the monopoly given by the government will be worthless.

Draghi Wants to Buy €60 Billion of Government Bonds Each Month

For a while now, Draghi has been buying €60 billion’s worth of mostly long-term government bonds. Besides a potential loss of confidence in the euro, Draghi seems to be facing several other obstacles on his way.

It is true that Draghi imposed a couple of rules on himself: out of each new bond issuance he is only allowed to buy up to 20%, and he can only own up to 33% of a country’s outstanding government debt. Draghi has also said he wouldn’t buy treasury bonds with an interest rate lower than -0.20% (the current deposit facility interest rate for commercial banks at the ECB).

But those are not the obstacles I am talking about right now.

The obstacles I am talking about are unforeseen obstacles; obstacles that make the market realize that the power of central bankers is very limited. They are obstacles that can lead to the end of the current PhD standard era and its 'monetary engineering.’

Another Obstacle: There Are Not Enough Bonds to Buy

It is no secret that the Dutch banks ING, ABN Amro, Rabobank and pension fund APG have already indicated that they will not sell government bonds to Draghi. The reason is simple: they must hold government bonds as capital (the so-called 'risk-free assets') and use these bonds as collateral for transactions. Furthermore, in case they would sell them to the ECB, they would not be able to do much with the proceeds. Yields are hard to find, and the ECB itself is not an alternative (because the deposit interest rate is negative).

In short, there are two options: the ECB will start buying an ever larger range of assets, with all sorts of (political) consequences. The Germans will scream blue murder and the German elections will be dominated by monetary problems. Another option is that the ECB has to give up and acknowledge the market as its superior.

For the first time in decades, the credibility of central bankers will be threatened. It will be first step to the start of a new era, and the end of the era of monetary engineering.

Bill Gross: German Bonds "Short of a Lifetime"

Bill Gross even went as far as calling the German 10-year government bonds “the short of a lifetime.” We have to account for the likelihood of German (and Dutch) bonds 'front running' to exactly -0.20%. True speculators are currently buying massive amounts of Dutch bonds, and the yield on Dutch 10-year bonds could undoubtedly drop even further.

I avoid these government bonds. Investing with little upside, but a lot of downside, is like "picking up pennies in front of a steamroller".

The biggest monetary experiment will undoubtedly end with financial distress. During this financial rollercoaster, central banks wouldn’t dare to sell their gold. They are net buyers of gold, and it is wise to follow their example. 

Newsletter

Sign up for our periodical newsletter to stay informed about the gold and silver markets and special offers.