Debt Mountains, Central Banks and Inflation: a fair life?

Recently the official minimum bid rate from the European Central Bank is set to a historical low of 0,05%. Worldwide, Central banks are printing huge amounts of new money. You might wonder what is happening here……?

In my online e-learning module Understanding Financial Markets Go to training, I explain that supply and demand of capital is one of the three activities that happen on financial markets. Two product types are used: shares and loans. If loans are used, borrowers (demand) and lenders (supply) have to agree about the price: interest. The interest level is determined on two financial sub markets: the money market for short maturities (up to 2 years) and the capital market fixed income for long maturities. Banks are the main players on the money market executing balance sheet cash management via interbank loans and deposits.

When we talk about markets, and we live in a capitalist system, most of us think that prices are set by supply and demand on the free market. However, the money market price setting is far from free: the short term interest level on the money market is determined by Central Banks. A Central Bank’s main task is to create a stable financial system. One of core conditions to create a stable financial system is that the value of money is stable. Money is important for our economies as oil is for an engine. Too little of it has devastating effects. A bit extra (say 2%) makes it possible for the engine to run smoothly, but not too much. So to prevent that the value of money does not increase (deflation), Central Banks accept that money value decreases yearly with 2% (inflation). The short term interest rate is one of the main intervention instruments that Central Banks use to stabilize the value of money.

The now historical low interest rate results from Central Bank interventions in the money market. The Central Bank assessment is that the value of money is too high. Central Bank lends money to banks at low interest rates in the expectation that banks make lending cheap to the public. The public is tempted by low interest rates to borrow and buy whatever they want: buy a car, house, bed, go on vacation. If we buy a lot, prices should increase and the value of money will stabilize.

But who can or wants to borrow? There is already a huge debt mountain (Creditalism as defined by economist Richard Duncan). In the past debt mountains have existed and disappeared by inflation, often also resulting in severe economic recessions. Therefore an additional instrument is used to devalue money: print money, also known as Quantitative Easing (sounds sophisticated).

We experience a new phase in Central Banks interventions that has never been done before. Repayment of the current debt mountain by future earnings is impossible and Central Bank intervention is needed to prevent a breakdown of the financial system and economic recession.

The low interest rates and Quantitative Easing is not yet resulting in inflation, but the effect is already the same. Saving money is punished by low interest rates – inflation also punishes savers. Borrowers are favored by low interest rates – and inflation rewards borrowers. The future will tell us if our Central Bankers have guided us smoothly from the debt mountain. Not fair for those who have savings (pensions). But nobody ever signed a contract that life was fair.

If you want to know more about banking and financial markets, I invite you to enrol in my e-learning courses Go to training, read my short e-book Go to book