Friday, 23 August 2013

Funny money (part 1)

 If I take out a loan of £10,000 from a bank, that money is created out of nothing. The money is deposited into my account and the bank has a signed agreement which says that I will pay the £10,000 back plus interest. It is an IOU.

Money represents debt not value. Virtually all the money in existence is based on debt. Without any debt there would be no money.

This system of money creation is known as Fractional Reserve Banking. This basically means that banks only keep a small fraction in reserve compared to the amount of debt they have on their balance sheets.

The European Central Bank (ECB) is just one of numerous central banks that have taken unprecedented steps to shore up the western banking system and thus prevent complete collapse.

In the last few years the markets have been reluctant to keep buying the debt (bonds) of Italy and Spain. The borrowing costs for these countries increased significantly.

As the result of this the ECB started to provide loans for these countries in exchange for some of the debt that the markets were unwilling to buy. These low interest loans are known as Long Term Refinancing Operations (LTROs).

During 2011 the ECB started to directly buy the debts of some weaker Eurozone countries. The decision to do this led to the resignation of the ECB’s chief economist.

As you can see from the chart below, the ECB’s balance sheet is expanding rapidly with the debts of Eurozone countries. What is the quality of this debt? Will it ever be repaid?

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