Money Markets

When ECB purchases bonds from private banks of 60 billion Euros (each month,) is ECB giving away free money to private banks?

Isn't that a good question? And the answer is actually both yes and no.

Before explaining why, we'll need a small recap on how the money markets work.

Have you heard the words "transmission mechanism," "bond market," "overnight lending," "maturity," "coupon rates," "yield," etc.? Always wondered what this is all about? Well, it's the core of Keynesian economics where the belief that money creation equals wealth creation. In this system inflation is required to get the "wheels going."

It's incredibly complicated. Almost to a degree where you think it's a conspiracy to prevent common people from understanding it. So this is how it works:

A Bond's Face Value

A government can issue bonds to finance itself. A bond is a paper that says "This is worth $10,000, but you'll have to wait 5 years." It is the responsibility of the government to pay $10,000 when the maturity of the bond expires, i.e. 5 years from now. Normally, it is unlikely that a government fails their promises as a government has the ability to raise taxes. Thus, defaulting a payment is ultimately a political decision. Of course, if a government chooses to default, it could be hard to sell new bonds they print. It's normally in everybody's interest that bonds don't default.

Coupon Rate

If you buy a bond and hold it to maturity you'll get its face value. In the above example it is $10,000. But bonds also come with a coupon rate. This will give the bond holder an annual pay in addition to its face value. A coupon rate of 10% (10% of $10,000), means that you'll get $1,000 in annual return. And if the maturity period is 5 years, it means that the total sum of cash you'll get is $10,000 + 5 x $1,000 = $15,000. Adding coupon rates is just a fancier bond, to make them more attractive. You could achieve the same thing by issuing more bonds with a shorter maturity period. In some sense, this is yet another deception to make things more complicated than necessary.

The Primary Market

When a government sells newly issued bonds, they do so on the "primary market." In practice, the primary market consists of all major banks in the country. The central bank is not allowed to participate in the primary market, because that would mean they would fund the government directly (remember: "independent" central banks.)

But at what price would a bank buy a $10,000 5 year bond with a 10% coupon rate? (= $15,000 in 5 years.) Well, that's up to the market. What happens is that the government issues these bonds and an auction takes place. Not too long ago these auctions were simply regular phone conference calls with all major banks being present.

But how do the banks determine a fair price? It is now it becomes complicated. Imagine a lousy deal: the bank is parking the money by buying a $10,000 5 year bond with no coupon rate at the price of $10,000. Why is this a lousy deal? Well, because of inflation. $10,000 today does not have the same purchasing power of $10,000 in 5 years from now if you have 1% inflation. We can calculate what that mature bond would be worth in today's money: $10,000 x (1 - 0.01)^5 ~= $9,510. This means that if the bond is not bought at $9,510, the bank would make a loss. Of course, if you have no inflation, then you would basically park your money for 5 years with no access which also is a lousy deal. So you would definitely guess right if banks would purchase these bonds for something less than $10,000 if we have no inflation and less than $9,510 with 1% expected inflation.

It is inflation that makes it very difficult for banks to determine a fair value for these bonds. What happens if inflation suddenly rises? Then all bonds will become worth a lot less. If there are no sudden events then it will still be a close to a lousy deal, because these bonds are sold at an auction it means that everybody basically has the same information about the future which means that the price of a bond will be very close to just "parking its purchasing power."

The Secondary Market

Once the bonds are bought from the government by the banks they can now be traded on the "secondary market." Participants in this market need to calculate the market value of these bonds based on two things: inflation forecasts and the yield to maturity of the bonds. The latter is simply obtained by calculating how much the bond is worth by looking at its static properties, i.e. the face value and the remaining coupon payments. This is then used as a benchmark to calculate its purchasing power w.r.t. inflation.

But there's one thing that makes the secondary market not a free market. Why? Because the central bank can buy these bonds and thus distort their free market values. This is called "quantitative monetary easing."

However, this quantitative monetary easing is already priced in when the bonds were bought on the primary market, which is why banks don't get "free money." The major participant who wins this game are the governments who'll get a lower interest rate when they issue the bonds.

BUT when ECB decides to increase its quantitative easing program, then suddenly these bonds become a lot more valuable, and the banks who bought them at the primary market before that decision, will now get free money. And when ECB is giving away free money, it is the society that gives away free money.

Conclusion

There it is. The answer to the initial question is both yes and no. It is still outrageous that the answer is ever allowed to be yes. A monetary system should never allow society giving away free money to private corporations. That's just wrong. So how do we prevent it from happening?

The answer is to separate money from the state (= dismantling the central banks.) Then the state will never be able to create money and give it to private corporations (= banks.) What is beautiful is that the separation of money from the state requires no political decisions. It just requires you to acquire and use bitcoin. Once we become the majority, the transition has happened.

If that happens it would be a major cornerstone in monetary history. Be proud taking part of it.

/ Datavetaren