The LTRO and why you should understand what it is. Yes You.

An LTRO, or a Long Term Refinancing Operation is an act by a central bank or other authority (in this case the ECB) to provide loans at below market rates to private banks.

Why is this important and does it work?

I’m writing this because yes, it is important and no, it’s unlikely to “work”. Let’s start again…the ECB has provided a facility to allow European banks (and yes that does include UK ones) to borrow from it at rates that those banks  couldn’t borrow at from each other. Think of it as the bank of mum and dad. So far European banks have borrowed more than €1trn from the ECB in two waves.

What led to this facility being introduced? Well, it’s commonly argued that the distrust different financial institutions had for one another, and their respective governments’ ability to do anything meaningful, meant that the normal course of business had simply broken down. By the normal course of business I mean that every day financial institutions lend and borrower from each other to manage their daily (and longer term) cashflows. Why? Well the world is a complex place and split into may fragmentary pieces all looking after themselves. The financial markets reflect this complexity meaning that even the smallest banks and financial institutions have complex needs, demands and requirements on their funds. If they aren’t able to meet those needs they can’t lend to you or me, nor can they lend to big companies and economies simply collapse.

So the liquidity problem is a real problem” for everyone. You can even look at the shortage of banks will to make mortgages as an upshot of this liquidity drought – so the LTRO should, in theory, improve your chances of buying a house.

However…given that the “problem” only exists because of bad debts and broken economies, shouldn’t we actually just suck up the pain and reset the profit and loss book? Why should we allow financial institutions to borrow from mum and dad when the reason they need to borrow is because they went broke and are scared all their mates might be bust too? Well, you want a credit card don’t you? I guess you want a debit card too. In fact I guess you want to be able to pay for food you haven’t grown yourself and drive on roads you’ve not laid. Without this pillar of modern life many other things become more difficult. Finance isn’t sufficient to get your food to you but it is a necessary condition.

Still, the point is a good one. If, after months of recession, recapitalization, shrinking balance sheets and the like, the financial markets still don’t trust themselves and, worse than that, they don’t trust their own governments shouldn’t that be a sign that we really need to get our house in order? Yes. And no. You can’t simply wave a magic wand and make this better. Governments have, with differing amounts of competence, point scoring, witch-hunting and wisdom, worked as hard as they possibly could to make things right and to steer their own countries out of disaster…but it hasn’t really worked yet. Indeed, if Japan is a model we’re doomed to follow, then two decades later it still hasn’t worked.

Which leaves us with hundreds of banks, possibly all of them, being unable to borrow from each other in a way that means you can have a mortgage and Tesco’s can pay its suppliers before it’s sold their goods.

The LTRO does a number of things – it allows banks to be less distrustful, and brings down the fear premium they’re charging each other to lend and borrow right now. It takes the pressure off of governments and allows them to focus on getting public spending under control without having to bail out more banks (or face the risk of atm’s closing down and you not getting paid). It also essentially monetizes bad debts. What do I mean by the last? Consider that I have to hold enough real funds to cover any potential losses I might face from bad borrowers. Now consider that holding those funds costs me money and every time a borrower does go bad those funds are used up in keeping me afloat. Well by borrowing cheaply from the ECB and lending it on at more expensive rates I can use the excess to rebuild my capital. In other words I’m negating the impact of bad debts…so mum and dad are bailing me out without taking me over. They’re slowly but surely giving me a fresh start.

So far so good. Except.

There’s no reason to say that this operation is large enough to restore trust. Governments are still locked into a very small range of actions that only some people believe will work. (There are many schools of economics that simply don’t believe what’s in western text books on economics – for the simple reason that it’s not proven and really just a bunch of ideologies we can all argue about until the cows come home).

Additionally, there’s no reason to say that there’s enough to actually help negate all the bad debts coming down the road. In fact it might simply be a case of Wile E Coyote standing with his finger in the cracking damn. Sure it buys some time but for what exactly? The outcome is the same but instead of short painful shock it’s long drawn out torture. Greece can’t get much worse but it can sure stay where it’s at for a long or shorter amount of time. No one knows what impact on that the LTRO might have. The LTRO might be the ultimate example of kicking the can down the road.

Finally, the LTRO is, in some people’s eyes, a proper example of moral hazard. If mum and dad bail you out two things happen. You don’t learn any lessons and they are lumbered with the consequences of your bad behavior/luck. In fact, if it’s bad enough they might lose their own home because of your actions and then you’re all boned. Not a great result.

I worry about the first and the third the most. I don’t think the two current competing economic ideologies are relevant. They are based on out of date concepts from physics and it won’t be until we truly start looking at  economies and agents as complex adaptive systems that we’ll move on. Our economics world views are 7 decades out of date.

But what I really worry about is the impact on you and me. Unthinkably high levels of youth unemployment. Women hit harder than men when two income households have increasingly on just been able to hold their heads above water. I worry about long term inflation prospects (not just on the upside but on the down where your debt actually becomes MORE of a burden because your income shrinks).

The people behind the LTRO see these risks and this facility is their last, best answer. It may not be enough. The cycle or pushing liabilities from the private sector to sovereigns to tax payers and finally spreading that between tax payers and supranational entities is reaching its final phase and the bad debts are still with us. Welcome to the beginning of the decline of the West. And that’s why I think you need to know about it.