I haven’t completely sorted this out yet but for a number of reasons I believe that the ECB has lost control of monetary policy in the Eurozone.
By that I mean the ECB is no longer controlling the marginal cost of funding and that indeed the cost of such funding is rising much higher than the official 1.25% rate, at least up to 2.25% and perhaps as high as 6 – 7%.
This incredibly contractionary monetary “policy” began sometime earlier this year and is continuing to accelerate. I put policy in scare quotes because there is no policy as such there is simply contraction.
Paul Krugman and Joe Weisenthal look at the growing spread between Sweden and Finland and conclude that failure of the ECB to act as Lender of Last Resort explains the difference. This is a position I would have endorsed as recently as yesterday, but now I am not so sure.
Based on entirely different indicators this looks to be the point where the ECB’s control over Eurozone monetary policy began to come unmoored.
At the crux of the problem seems to be the inability to arbitrage away differences in funding costs between institutions and countries because of malfunctioning in the European Repo market.
This malfunctioning appears to be down right mechanical with trades regularly not settling on time, collateral not being delivered, awkward interventions by local regulatory agencies and a host of other deep, deep problems.
I don’t have it all sorted out but its not clear that there is a fully functioning money market in Europe right now. Well informed opinion suggests that there is literally a shortage of know-how on the ground. That is to say, some large banks or brokers cannot trade in certain types of paper because they don’t have anyone on staff who knows all of the relevant institutional details.
Its really maddening and quite disconcerting.

21 comments
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Tuesday ~ November 29th, 2011 at 3:15 pm
123 TMDB
There is are no mechanical malfunctions. Monetary policy is too tight, and accordingly, risk premia are too high.
Tuesday ~ November 29th, 2011 at 3:34 pm
Curt Doolittle
Hopefully the ‘great project’ will unwind. One can only hope.
FWIW: I transferred my holdings in swiss francs to singapore in August.
Tuesday ~ November 29th, 2011 at 5:27 pm
The Daily Climb « georgesblogforum
[...] and their impact and influences on audiences and social [...] Jon-Paul Modeled Behavior FeedThe Euro-Crisis is Much Worse Than It Looks November 29, 2011I haven’t completely sorted this out yet but for a number of reasons I believe [...]
Tuesday ~ November 29th, 2011 at 6:30 pm
bena gyerek
could it be that the snb is sitting on all the quality collateral?
i did a rough calculation that snb intervention since setting the eur/chf floor has been the equivalent of about 40% of the german short-dated govt debt market. that has to have an impact.
Tuesday ~ November 29th, 2011 at 8:22 pm
rjs
just an addendum: http://macromarketmusings.blogspot.com/2011/11/fateful-decision-to-tighten-ecb.html
Tuesday ~ November 29th, 2011 at 10:03 pm
Mike
We are gonna get fucked square in the ass on this one.
Tuesday ~ November 29th, 2011 at 10:13 pm
Josh
“Paul Krugman and Joe Weisenthal” — Weisenthal has made a point of linking to this post, just so everyone can see him referenced in the same sentence as a Nobel winning economist.
Tuesday ~ November 29th, 2011 at 10:21 pm
Failed Eurozone Austerity Measures Show European Leaders Asleep at the Wheel - Forbes
[...] in Europe may be too late, even if they were to turn the austerity ship around. Karl Smith thinks the ECB has lost control of monetary policy altogether: I haven’t completely sorted this out yet [...]
Tuesday ~ November 29th, 2011 at 11:41 pm
News: The Situation In Europe Sounds Kind Of Bad… | News 25/7! Delivering news in real time
[...] professor Karl Smith writes on his blog Modeled Behavior that the situation on the ground is more grim than people [...]
Wednesday ~ November 30th, 2011 at 12:30 am
The Situation In Europe Sounds Kind Of Bad… – Finding Out About
[...] professor Karl Smith writes on his blog Modeled Behavior that the situation on the ground is more grim than people [...]
Wednesday ~ November 30th, 2011 at 1:08 am
R Foreman
Gov’t involvement in private markets IS the problem. Let the insoluble debt be defaulted and written off. Time to let the creditors eat it for their bad gambling problem. Don’t allow lending of money you don’t have (fractional reserve banking), and DON’T MAKE LOANS THAT CAN’T BE PAID BACK. ‘Nuf said.
While we’re at it, why is it that bankers require government assurances to stay in business? Banking is a government enforced counterfeiting cartel. Without gov’t force the lenders would be MUCH more prudent.
Wednesday ~ November 30th, 2011 at 8:14 am
dausuul
@R Foreman: Learn some history. We didn’t always have a Federal Reserve, or fiat currency. And in that pre-modern economy, banking crises happened like clockwork every 20 years or so. You sound like Herbert Hoover’s Treasury Secretary saying to “liquidate everything” and “purge the rottenness from the system.”
Wednesday ~ November 30th, 2011 at 1:21 am
The Situation In Europe Sounds Kind Of Bad… | Athens Report
[...] professor Karl Smith writes on his blog Modeled Behavior that the situation on the ground is more grim than people [...]
Wednesday ~ November 30th, 2011 at 2:02 am
The Situation In Europe Sounds Kind Of Bad… | ATMACK Call Us Toll Free: 855-286-2251
[...] professor Karl Smith writes on his blog Modeled Behavior that the situation on the ground is more grim than people [...]
Wednesday ~ November 30th, 2011 at 3:22 am
The Situation In Europe Sounds Kind Of Bad… | My Blog
[...] professor Karl Smith writes on his blog Modeled Behavior that the situation on the ground is more grim than people [...]
Wednesday ~ November 30th, 2011 at 5:06 am
Daily digest: Please help us IMF : Beyondbrussels.com
[...] For a long time many have avoided to talk about the possible outcome of a eurozone break up as a consequence of the eurozone debt crisis. But now the situation is being analyzed and the outcome isn’t at all utopia anymore. In this article Der Spiegel International analyzes what will happen if the eurozone break up, and in this blog the economist Karl Smith says the euro-crisis is much worse than it looks. [...]
Wednesday ~ November 30th, 2011 at 7:03 am
More Europessimism | FavStocks
[...] More Europessimism, by Tim Duy: I hate to beat a dead horse, but the situation in Europe is dire, and two issues crossing my desk this afternoon only add to my angst. First, Karl Smith at Modeled Behavior sees that the ECB is losing all control of monetary policy: [...]
Wednesday ~ November 30th, 2011 at 11:53 am
Phil Koop
This post is much better than your previous one.
There are two lessons drawn by the NY Fed from the US repo market that are relevant to this situation. The first is that although in theory repo depositors (i.e. end lenders) are supposed to be made indifferent to credit risk by collateral, in fact most corporates deposit on the reputation of the name of their counterparty; they do not want to have to deal with the legal and operational issues of liquidating collateral. So how do they park their money if they can’t find a trustworthy counterparty, then? Perversely, they buy the collateral bonds outright! I guess they figure that if they’re going to end up owning the bonds anyway, they might as well eliminate legal risks.
Second, in a low-IR environment repo market makers have a perverse incentive to fail on settlement because this in effect gives them free funding. The market can muddle along with this situation in normal circumstances, but when funding of any sort is hard to come by, this is naturally going to exacerbate the situation. The US Treasury has found it necessary to impose a change of market convention and charge for fails.
See http://www.ny.frb.org/research/epr/10v16n2/1010garb.pdf.
Wednesday ~ November 30th, 2011 at 1:55 pm
BullseyeMicrocaps.com » More Europessimism
[...] my desk this afternoon only add to my angst. First, Karl Smith at Modeled Behavior sees that the ECB is losing all control of monetary policy: Based on entirely different indicators this looks to be the point where the ECB’s control over [...]
Friday ~ December 2nd, 2011 at 1:03 am
Economics and Investing: - SurvivalBlog.com
[...] Karl Smith: The Euro-Crisis is Much Worse Than It Looks [...]
Wednesday ~ December 14th, 2011 at 11:50 pm
spiritofjubilee
Hello Modeledbehavior,
Very interesting, No Profile Comment
Great Job!
In America: governments, businesses, individuals are now buried under a mountain of debt. A mountain of debt that will never be repaid.
Who will borrow when they can’t make the payments on the debt that they have already? The math alone calls for a system reset, a debt jubilee.
Investors are already losing… in a rigged monetary casino that rewards usury, speculation, and currency manipulation while looting main street.
There is a moral principle that debts should be honored. That is, debts between businesses that buy and sell real products, not bundled ponzi schemes, debts between individuals, between friends and businesses that know each other to be rational and moral, debts based on investments where there is a rational expectation of return.
There is also a moral principle that unjust debts should be cancelled, and usury legislated against. Debts that are ‘odious’, debts based on fraud, debts to dictators, debts arranged by oligarchs without the consent of the general population (the 99 percent who have been left out of the equation), debts based upon compound interest upon compound interest, that should have been written off long ago, the debts need to be cancelled in a general jubilee. Think outside the box. It’s time for a jubilee.