Last Thursday – 3rd of December, the ECB boss Mario Draghi found himself in a rather awkward situation. Markets expected him to come to the party with a fully loaded Bazooka and Draghi believed he had one. Alas, as the day wound to a close, the street thought he was armed with a slingshot and a couple of pebbles to boot. Now, remember, we’re not talking about just another central banker here. Mario Draghi or ‘Super Mario’ easily takes the cake for his mastery of the dark act of central bank communications. Back in 2012, bond markets were in tailspin, fearing an imminent collapse of Greece and the Eurozone peripheral economies. Draghi then came up with the now famous “whatever it takes to save the Euro” line to calm markets and reverse panic. I’ve been an unabashed fan of the guy ever since and rightly so for the ECB really didn’t have to wield many of its weapons in the aftermath. Indeed, if one were to rank policy announcements by “bang for the buck”, those few words spoken in a London conference on July 26th 2012, would rank right at the top of the list. But this time, it was the rabbit that he didn’t pull out of his pocket that got panicked traders to stampede in a rush to exit their crowded short Euro and long eurozone fixed income trades.
But I’m getting a little ahead of the story. Here’s what happened earlier that day. The ECB was to announce an expansion of their monetary stimulus program and expectations had set in for a stronger impetus of Quantitative Easing. Up until then, the ECB’s ultra dovish stance gave no signals to the contrary. The ECB was already buying 60 billion € per month in bonds as a part of its QE program and the consensus was in favour of an increase to 80 billion €. Eurozone deposit rates were already in negative territory at -0.2% and a move to -0.4% was no longer considered obnoxious. Finally, the QE program was due for a further extension to March of 2017. The problem in the end was that Draghi did his bit but came up short. The 60 billion € per month figure was unchanged and eurozone deposit rates were reduced to only -0.3%. As it happened, just a tweak caused the Euro to gain 3% against the Dollar, its sharpest gain since March 2009. The Euro came close to the 1.10 line before settling in at 1.0920. Markets across the board witnessed a selloff, the biggest since September.
There’s been speculation that the climb down owed much to the Bundesbank’s bullying tactics. Here’s what the Guardian had to say
“The second – and far more likely – explanation is that Draghi wanted to do more but had been prevented from doing so by divisions on the ECB council. It has been clear for some time that the Bundesbank president, Jens Weidmann, opposes an expansion of QE, and his was probably not the only dissenting voice.”
The consensus view today is that Europe has an output gap as demand is lacking and unemployment for the eurozone is still elevated at 10.7%. Inflation at 0.1% is significantly lower than the ECB’s target of 2% and producer prices are falling. But is QE and negative interest rates indeed a solution to slack in demand and low inflation faced by the Eurozone? I’m not really a fan of QE but that’s not to say that it has helped in the sheer absence of any other alternatives acceptable to Eurozone members. In fact my endorsement of QE is akin to the way I see politicians. I cast my vote for those I presume are ineffective and awful to avert a worse disaster. In the process, I end up despising the system a lot and myself a little less.
QE in its original version goes back to the Bernanke Fed and some also draw a parallel with the Bank of Japan’s stimulus in the late 90’s. The common intention was to boost investment in the real economy and thus stimulate employment. Back in 2008, a constraint was that short term interest rates were already at close to zero. Standard stimulus for economies in recession – reducing overnight interest rates, was no longer possible. In its basic form, QE was a large scale injection of liquidity into the system by the act of central banks buying government and other debt securities from banks. It was hoped that some of this money would flow via banks into the real economy. An increase in liquidity was also expected to drive interest rates down, especially at the longer end and the Fed hoped this would incentivize businesses to borrow and invest in tangible assets. Now in hindsight, we know that successive rounds of QE in the US were not successful in their primary purpose – rejuvenation of the real economy. As Cullen Roche wrote in this very interesting piece back in 2011, QE failed to translate to higher lending, investment or consumer spending.
So, if the reserves in the system created by active buying by the Fed did not cause a boost in lending where did they end up? There are two kinds of prices – consumer prices and the price of savings. The latter is the price we pay today for assets – property, bonds, equities etc, in order that we may consume in the future. This is where liquidity has gone and what we’ve got in return is a speculative rally in asset prices. Surely not a bad thing one may say but it’s not a very productive transmission channel. Moreover, there’s always the risk of a bubble in asset prices. Then there was the currency channel. An increased supply of Dollars cheapened the currency and helped American exporters regain some competitiveness. That said, each successive round of QE came with diminishing returns on these fronts.
Returning to the Eurozone, the ECB was a late convert into QE and it was only earlier this year that a formal bond buying program was announced. Nonetheless, almost € 700 Billion worth of liquidity injections have taken place till now. Again, the currency has been the main transmission channel. The Euro has depreciated against most of its trading partners and exports have gained. But currency depreciation is temporary at best. And while it does help in isolated instances, it’s a lost cause in times (like today) where every country aims to outdo the other at currency weakening.
As in the US, real demand is yet to show up. The bank lending channel has been dismal and credit growth continues to remain sluggish. Put very simply, the banks have been unwilling to lend and the public resistant to borrow. Here’s what William White, former chief economist of the Bank for International Settlements had to say
” The fundamental problem here, as I see it anyway, is that the European banking system is still broken. As you know, the European economy is heavily reliant on small and medium-sized enterprises, and they are reliant in turn on bank financing. Unfortunately, it is these firms that are not getting the bank financing that they need. Until that gets fixed, we will continue to have a huge problem in Europe.”
“Economists have been warning for a long time that when interest rates are close to zero, quantitative easing alone will not be able to stimulate the economy. The reason is that when interest rates are close to zero the liquidity that the central bank is creating does not easily filter into the real economy. Most of it is hoarded because the opportunities to find attractive rates of return are limited. Many financial institutions then prefer to accumulate the extra liquidity created by the ECB without doing anything productively with it. This is the well-known liquidity trap.”
Both views give credence to the argument that in the current “credit trap”, most QE money goes toward savings rather than what we might call “real goods.” We have sustained increases in the price of assets – stocks and real estate. But a boost in demand for goods and services fails to materialize. This is why I am sceptical that QE will work and why I think it can potentially do some real harm.
Those who argue in favour of QE pose the query – what if there was no QE? Would that not have kept interest rates high, caused lending to fall even more and stalled even a nascent recovery? Would we not have an entrenched deflationary environment if not for the wealth effect from asset price rallies?
QE to my mind is a bit like cholesterol. When there are nicks in our arterial wall, the body recruits a handyman to patch up those nicks with grout. That grout is cholesterol. But not any grout is effective. In fact there is good cholesterol – sort of premium grade that does a great job. So, we needed QE in the beginning as conventional ammo in central bank armouries was not helping the cause. This version was a lot like good cholesterol. However, there is bad cholesterol as well and if your cardiologist talks about a traffic jam in blood flow, look no further for the culprit. We’re now at a juncture where markets are addicted to stimulus and every incremental injection of liquidity offers marginally diminishing returns. Worse, it might even pave the way for a bubble in asset prices. And there’s every reason to believe that the bubble will not be limited to the Euro area itself.
In a series of papers starting March 2014, Deutsche Bank strategists George Saravelos and Robin Winkler introduced a concept that they named “Euroglut”. The basic premise was that the Eurozone has since 2011 run sustained current account surpluses – higher than any other time since its inception. Surpluses reflect the predominance and persistence of savings over investments in all sectors. As examples they cite the instance of Euro area governments having tightened fiscal policy in the austerity race while households are still saving post the recession. The Eurozone corporate sector has built up profits thanks to healthy exports (especially by the German and North European coterie) but most of that has been applied to reduce debt than invest in Europe itself. The Deutsche Bank strategists concur that a fundamental problem is the lack of domestic demand within the Eurozone. That high current account surpluses and high unemployment rates are symptoms of this. They point to the fact that the large current account surplus has initiated a process of large scale capital flows from the Eurozone (indeed an accounting identity – a surplus on the current account implies capital outflows elsewhere). Capital flowing out has found its way into foreign portfolio assets – fixed income and equities in the UK, US and emerging markets. Now imagine what is likely to happen to nearly $ 500 Billion to 1 Trillion worth of excess cash lying in Euro area bank accounts and earning negative returns of -0.30 %. The ECB is only likely to heighten the European search for yield abroad as it engages in monetary easing via QE and negative interest rates. As a result the Euro could witness broad based weakness over many years as “Euroglut” plays out. Needless to say, one central banker lost some of his credibility with the markets last week but his war with the imbalances of the Eurozone continues.
Meanwhile as Draghi grapples with his set of worries, the world’s financial press only has ears for one bit of news now – the imminent hike in US interest rates by the FOMC. Now this one should be devoid of surprises. I’ll be around with my take on that soon enough.