“By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens.” – John Maynard Keynes

Something Rotten in the EEC 

In mid-March, the European Central Bank (ECB) took a bold new step towards trying to deal with the debt it has accumulated since its chief economist announced the bank’s intention to “make sure the yield curves do not move ahead of the economy.”

What does that mean?

It means that it’s going to do everything in its power to create a negative gap between the interest rates that investors will get for buying ECB bonds and inflation.

Still confused? So am I! Let me try again.

The ECB is trying to create a situation where ECB bond holders – people and institutions that support the EEC lending the ECB billions of euros (by buying ECB bonds) – will get shafted by seeing the rates they are getting on those bonds eaten up by a higher rate of inflation.

You believe in the EEC. So, you lend the ECB a million euros for 10 years. This IOU (bond) comes with a guaranteed 2.5% return (yield) on your million euros. You check your investment calculator. In 10 years, your investment will be worth about 1.3 million euros. Not a lot, but something.

Or so you think. What you don’t know – or aren’t aware of – is that the ECB is planning to keep inflation at 5.5% over that 10-year span.  That three-point gap between the 2.5% yield you are getting and the 5.5% yearly devaluation of the euro has made you poorer. Instead of making 300,000 euros, you’ve actually lost about 300,000.

This is bad news for the bond investor, but good news for the government that creates this policy. A negative 3% real yield brings down the real value of a government’s debt load by 46% over 20 years. And a negative 5% real yield brings it down by 64% over 20 years.

If this sounds like the EEC has decided to make its lenders pay for its overspending, you are seeing it the way I do. But it’s a clever policy because it is (1) gradual, and (2) indirect, and therefore almost nobody understands it.  And if anybody does get it, it can easily be explained as the natural fluctuations of the market. (Not true.) And if that fails, it will be revealed as another way of taxing the rich. (Bond holders are generally rich.) So who cares?

It is a clever policy. Not just because it will fly under the radar, but mostly because it will be tolerated by the people that are being robbed. It’s an extra “tax” on their bond holdings. And not a huge tax. Just a few percentage points. The ECB won’t be biting off the hands that feed it. It’ll be merely nibbling at them, at a rate of 3% to 5% per year.

In a recent issue of Postcards from the Fringe, Tom Dyson called this a form of “financial repression… when big, heavily indebted industrialized countries turn their sovereign bonds into certificates of confiscation in order to reduce their debt.” By pushing inflation rates up while keeping yield curves down (below inflation rates), they “effectively create a tax on holders of government bonds by probably something like 3% to 5% a year.”

It’s been done before, Tom argues.

“From 1945 to 1980, the US Federal Reserve mostly kept inflation a few percent over interest rates – not like this. It’s not too much that it scares people to dump bonds, but enough to keep the debt pile shrinking consistently over the long term.”

So, a question for those of us who have, in the past, liked the idea of lending our government our money in return for a guaranteed return: Does it make any sense anymore?