OCTOBER 2016

The Pawnshop of Promises


Central banks need to learn lessons from medieval banking, when interest rates were also at zero. Continuing to view the world through the lens of ‘interest rates’ is not longer sufficient.

Bishop of Myra, Slugger of the Nicaean Council, patron saint of nations and pawnshops, St. Nicholas is embraced by all Christian traditions and also secular ones, albeit under his alter ego, Santa Claus. His logo, of three golden balls, refers to the story of how he saved three daughters from servitude by silently tossing bags of gold into their home, offsetting the family’s liabilities by paying for their dowries and clearing their ‘balance sheets’.

In medieval times St. Nicholas’s charitable actions manifested themselves in the establishment of Christian pawnshops known as ‘Monte di Pieta’ (mounts of piety) - which attempted to apply the concept of collateralised lending against assets at a minimal rate. A Christian could bring in an asset, be given money at a haircut, returning the money at a stated time with a minimal charge.

This model was in direct competition with the already existing Lombard (pawnshop) lending system. Although Lombards verbally adhered to the prohibition on usury, keeping their headline interest rates at zero, they built in fines, exchange rates, total return swaps and other small print to make their loans lucrative. The fact that every city across Europe still contains a ‘Lombard Street’ indicates their widespread use.

As long as the stated interest rate was zero the authorities remained satisfied; the concept of a zero interest rate policy (ZIRP) or even a negative interest rate policy (NIRP) was common to the medieval banker, it was the ‘official normal’. The key for the Lombard was how to embed a real interest rate into the asset and make the investment profitable.

Usury bans return
Since 2008 the ZIRP means that the admonition against usury has made a come back. But only our present day Church (a.k.a. the government) and its disciples (the banking system) receive the charitable ‘Monte di Pieta’ rates; for the rest of us it is back to the days of the Lombard. Access to credit is based on collateral. The better the collateral, the better the rate of interest. So we return to a Medieval world of balance sheets and not of interest rates.

This creates some amended articles of faith:

  1. Spreads are the new rates

  2. Balance sheets expand

  3. Liquidity is elusive

The central bank has become our modern day Lombard.

Stranded at zero
Central banks are now stranded at ZIRP not for an ecclesiastical embargo but a worldly one. Their engorged balance sheets are utterly intertwined with its primary customers - the government and the banking system. There is now an interlocking balance sheet trinity between the central bank, the government and the financial sector, making it impossible to untangle or reduce one balance sheet without effecting all the others.

These interlacing balances sheets remove from central banks their traditional interest rate flexibility and the ability to be ‘lender of last resort’. These attributes have been replaced with flexibility of the balance sheet and becoming the ‘dealer of last resort’. Like old Medieval bankers, central banks take collateral, give cash, charge a low rate (for primary clients), and are willing to buy and sell at the widest price spreads for the rest of us. Hence the endless chatter about ‘financial conditions’, otherwise known as the interest spread between assets.  

The Medieval Mindset
The return to Medieval banking brings with it a return to the Medieval mindset. If zero rates are the norm, then how do you balance low rates for the government and banks with high rates on consumer and mortgage rates for the wider populus. Confusion over this seeming unfairness slowly simmers to anger with the results already being seen in our politics.

A glance at Medieval times may again be instructive. In the late 13th century monarchs across Europe, such as Edward I of England, and Philip the IV of France removed  Lombards from their realms, using the taint of usury as the reason, and implicitly reducing and writing off the debts of peasants, lords, and the monarchs themselves. This smashed the balance sheets of scores of Lombards into oblivion as well as destroying asset prices. Given the intertwined nature of our current balance sheet trinity, any balance sheet reduction is going to be similarly destructive to asset prices. Therefore central banks need to learn from St. Nicholas by becoming Monte di Pieta lenders for all customers and start throwing bags of gold to the rest of us to offset our debt predicament.







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