Why the ECB suddenly decided to flood banks with money?

European Central Bank President Mario Draghi attends a plenary session of the European Parliament in Strasbourg. (European Parliament photographic library, 16/04/2013)

It was not a coincidence that the Governing Council of the European Central Bank  suddenly decided unanimously last week to further relax its monetary policy promising more and cheaper loans to all banks, exactly at a time when the US central bank, the Fed, is about to start calling back the trillions of dollars it spread around the world during the last three years, a large part of which has ended up in Europe, searching for higher yields. However fund managers in the US have now taken the message and are already abandoning or about to abandon placements in Europe in order to be able, as from this September, to face up to the changing monetary conditions at home. That’s why the Americans are obliged to leave Europe. Let’s follow the facts.

The US banks got rich again

After the great credit crunch in the American financial markets and the bankruptcy of Lehman Brothers the US government and the US Federal Reserve (Fed), the country’s central bank, adopted an all-out fiscal and monetary policy to keep the economy liquid. The Fed reduced its bank refinancing interest rate to zero and purchased whatever debt paper was on offer. In this way the Fed flooded the banks with zero cost dollars. The American lenders of course started their old tricks investing this money on risky placements all over the developing and the developed world. Turkey, Brazil and Asia were flooded with American dollar placements in sovereign and commercial debt. Even worse the US banks invested also in more risky placements in all and every possible commodity market.

In this risky way the American banks were quick in recapitalising themselves. Of course all that was based on the Fed’s notoriously relaxed monetary policies through this extraordinary programme of purchases of whatever assets were on sale by the banks. At that time those assets produced by the banks didn’t worth even the paper on which they were written, but the Fed didn’t care.

The US banks lent to Europe

The American bankers of course didn’t forget old Europe. In Eurozone too there were a lot of risky and high yield placement options, being that Portuguese, Italian or Spanish sovereign bonds. There were also high yield placement options in Eurozone bank debt and the Americans unloaded billions of zero cost Fed dollars also in this market too.

There were times when the American banks advertised to Europeans that they had $20 trillion ready to be placed in European debt, if the Eurozone decided to borrow more and be buried even deeper in debts. Seemingly this was the last drop in an already full glass and the American and the European authorities started to fear a new credit crunch. The bubble in the debt market came again close to burst fed with trillions of US dollars. The alarm bell rang in the Fed and its President Ben Bernanke started talking about slowing or halting asset purchases. Of course this is not an easy project to realise. The US banks must slowly abandon their risky placements and start returning some of those dollars to the Fed. The bonanza of American dollars around the world cannot be supported any longer.

In any case the Fed’s goal to indirectly recapitalise the American banks through its zero cost financing has already been achieved. Within four years the New York banks managed to restore their profitability and in this way to recapitalise again themselves, swiftly purchasing back their shares from the US government. Not to forget that the Washington administration spent trillions recapitalising the American banks during the difficult days of the 2008-2009 winter. Within two years however the banks started acquiring back those shares from the government and of course the American administration never thought to use them to exercise control on the New York banks.

Now the American banks are about to leave Europe. Undoubtedly they will leave behind them a very large financial gap that must be filled in. The European debt which was buoyed with U.S. Federal Reserve money has to change hands, if the west is to avoid a new credit crunch, worse than the last one.

ECB to succeed the Fed

At this point enters ECB. Within a few hours its Governing Council unanimously decided last week that the dollar gap has to be filled in with euro. Without the slightest hesitation the Council decided not only to further reduce its interest rates soon but to accept any demand for refinancing from Eurozone’s 6000 banks. In this way the Eurozone banks, most of which are undercapitalised and in the risk zone, will succeed their US peers, in holding the European debt.

To achieve this, the ECB must be as generous for the Eurozone banks as the Fed was with theirs. The basic interest rate, presently at 0.5%, must be reduced closer to zero, the amounts of money should be unlimited and the time horizon of this arrangement very long. To this effect ECB’s President Mario Draghi, addressing last Monday 8 June the European Parliament was adamant. He said “the Governing Council sharpened its communication by announcing that it expects the key ECB interest rates to remain at present or lower levels for an extended period of time”. He also clarified that “(the Governing Council also) reiterated that its monetary policy stance will remain accommodative for as long as needed”.

All in all the ECB is now obliged to use the American recipe of very relaxed monetary policy. Even Germany cannot argue with that. The reason is that it’s the German and the French banks which now need the generosity of the ECB in order to adequately replace the American connection.