Friday, 22 November 2013

Yes, Draghi!, You're Getting Closer!!

In his "Opening speech at the European Banking Congress “The future of Europe” Draghi today explained some concerns he had with ECB's monetary policy,
One concern is that low interest rates erode people’s savings. Another is that low interest rates create risks for financial stability. A third is that they reduce the incentives for governments to reform.
Yes, Draghi, absolutely correct:  Savings is crucial for any economy to prosper and to achieve sustainable economic growth as savings make funds available for investments. Artificially low interest rates leads to malinvestments which become visible for all to see when credit becomes more scarce and at higher interest rates. In addition, when they are kept artificially low, interest rates are no longer able to perform their crucial function as a brake for credit growth. Hayek explains the "interest brake" as follows (here),
The immediate consequence of an adjustment of the volume of money to the 'requirements' of industry [read: the creation of credit not backed by prior savings, i.e. the creation of money out of thin air through fractional reserve banking] is the failure of the 'interest brake' to operate as promptly as it would in an economy operating without credit.
Artificially low interest rates (brought about by fractional reserve banking, central bank asset purchases and the setting of low discount rates) thus make it possible for governments, and other borrowers, to take on more debt than they would be able to service (and probably wouldn't have been granted) if interest rates were higher (i.e. not artificially low). Central banks have therefore, directly and indirectly, contributed to the high level of sovereign debt in for example the U.S., Euro Area and Japan. 

Unfortunately, the majority of the Draghi speech contains the usual nonsense, such as presenting The Single Supervisory Mechanism as a solution to financial stability. As I have written on numerous occasions, the SSM or any other form of regulation is not the solution. Socialism and central planning don't work!! Rather, the current monetary system with fractional reserve- and central banking is inherently unstable -  no regulation can tame it. As long as it exists, the boom and bust cycle will continue as we know it. The only stable financial system I know of is one where credit and money is not created out of thin air, a system where credit is only granted from a commensurate amount of prior savings. 

But Draghi, or any other central banker, would never suggest such sweeping changes. I am not even sure they are aware that credit growth not backed by prior savings is the fundamental cause of "financial instability". 

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