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Has the European Central Bank saved the world?

Economist Andrew Hunt looks at the European Central Bank's decision to try quantitative easing and asks whether it is enough to save the European economies.

Sunday, February 8th 2015, 2:20PM

by Andrew Hunt

The author has recently been helping out with the coaching at his son’s “Minis Rugby” club and, although the team has had some notable successes of late, one of the problems we find is that when a seven-year-old novice catches the ball (which is not in any case guaranteed to happen….) you never really know which try line they are likely to aim for – their own line or the opposition’s. On more than one occasion we have had players attempt to score at the wrong end.

We relate this story simply because it seems that the ECB’s President, Mario Draghi, is now going to pass EUR60 billion into the hands of the financial community (via the ECB’s bond purchases) every month and then see which way they run with it. 

The ECB is clearly hoping that the world’s and, in particular, Europe’s investors will take the ECB’s new, very generously-provided funds and either invest them in the Eurozone Periphery so that they can provide some form of monetary stimulus through either the region’s banking systems (unlikely) or, more probably, via the securities markets. This is how “money printing” is supposed to work.

Some within the ECB may also be hoping that some of these funds find their way outside the Eurozone, thereby orchestrating a further competitive devaluation of the Euro on their behalf. There are those within Europe that want an even weaker Euro exchange rate and a number of the major brokers are forecasting further decline in the external value of the Euro, but we would caution that were the Euro to weaken too much further and, conversely, were the USD really to strengthen further, then this could not only increase the deflationary pressures in the US and elsewhere, it might also cause problems within the emerging markets as the viability of an estimated USD6 trillion of carry trades were undermined.

In this context, we would note with some interest the rather disconcerting comments on this topic by William White (ex BIS Chief Economist, more latterly at the OECD) at the recent Davos Economic Forum. A stronger dollar courtesy of the ECB’s actions may be the last thing that the global economy needs at this point.

Returning to Europe, we also suspect that something else that Draghi will not want to see is the Spanish, Italian or other peripheral central banks buying bonds from existing investors in their respective debt markets only to find that the vendors of these instruments then simply use the proceeds to move their money into the core European bond markets in some form of deflation trade. Were this to happen, then the peripheral countries would be left facing significant deflationary balance of payments deficit positions that would likely force real interest rates higher in these countries and, at the same time, leave these countries ever-more reliant on short-term ECB funding through what is known as the TARGET2 system. The TARGET2 mechanism is a theoretically completely automated credit system within the ECB that was initially designed simply to provide “frictional” short-term credit to member states but it has, over recent years, morphed into what has become a massive stabilisation fund that has provided trillions of “invisible” long-term Euro credit from the core countries to the Eurozone’s weaker economies. 

If the TARGET2 imbalances were to increase as a result of Draghi’s actions, though, then it would quickly make a mockery of the ECB’s rather contrived “country risk sharing” calculations that it emphasised in its policy announcement. As the TARGET2 balances expanded, any secession risks associated with any country would automatically be transferred to the balance sheets of the system’s creditor central banks in the core and we doubt that these countries – who have already voiced their concerns over the ECB’s actions – would be overly happy with this event…...

Given these various issues, it therefore seems to us that the only practical way that the ECB’s policy actions may not ultimately make the global situation worse would be if most of the money that it creates through its bond purchases finds itself flowing into – and staying in – the peripheral countries and if the Euro itself does not become too much weaker. For this to happen we believe that not only markets but also “real people” will have to believe that Draghi has in fact done enough to stave off deflation and foster what will ultimately become an inflationary recovery.

Has Draghi done enough?

We may be biased but we found Draghi’s performance in the press conference far from inspiring (not to mention the irony embedded in the fact that the ECB’s elevators stopped working just as he tried to get to the press conference…).

To us, his commentary seemed rather thin; there was the headline QE number that sounded impressive and will make for suitable soundbites on the national news but, less positively, he also emphasised the simple fact that Europe, if it is to fully recover, will need some help from fiscal policy and, most of all, from structural reforms. There was, though, no mention of any of this “being in the pipeline”; talk of a new fiscal stimulus was certainly conspicuous by its absence and the process of structural reform will take years to take effect, even if it were commenced forthwith. It seemed to us that the lack of detail or even comment on complementary policies was especially significant and hence the whole performance gave the impression of a central bank that was doing something simply because it needed to be seen to be doing something rather than because it expected it to work.

To our eyes, he even seemed to give the impression that he felt that the ECB was already acting “too late”. In addition, we might suggest that in his prepared remarks was probably not the right forum to admit that the ECB’s earlier and much-hyped efforts had not really hit their quantitative goals – such comments tend not to breed confidence in the next policy. 

We also found it a little strange just how much time was devoted to the whole risk-sharing/mutualisation of risk between countries within Draghi’s statement. As the ECB buys sovereign bonds, it will implicitly be acquiring “risk” and it seems that the issue of just how any losses that might occur as a result of this might be apportioned seems to have occupied much of the ECB’s time over recent weeks. If Europe truly were one country heading for the type of fiscal and ultimately political union that would make the Euro a “real” currency, though, then the discussion over risk-sharing would simply not have needed to have taken place.

The fact that risk-sharing had clearly been a hot topic of debate was probably not a helpful state of affairs and Draghi himself referred to it as being a futile discussion (that had clearly irked him). To make matters worse, the Finns had decided an hour or so before the ECB meeting to voice their objections to any potential new Greek debt deal, something that may now be necessary following the Greek elections and this also seems to represent another headwind for the cause of greater European integration and policy credibility.

Therefore, the ECB itself, Europe’s politicians and the Greek electorate may have already undermined the credibility of the ECB’s actions before they have even begun.

In conclusion, the all-important question as to whether the ECB’s actions last month will have been sufficient to reflate Eurozone inflation expectations boils down to the simple question of whether the EUR1 trillion headline number is a big enough statement on its own to Europe’s wider population to offset the technical deficiencies, the glaring lack of a display of EU unity, the lack of complementary policies and, we would argue, lacklustre delivery of the package.

Our judgement at this time is that when markets end their predictable knee-jerk reaction and begin to look at the details, they will probably decide that not much has really changed in Europe apart from the amount of money that they now have to “play” with. 

Certainly, we are doubtful that Draghi has yet done enough to reverse the recent decline in Eurozone expectations and so there remains a real risk that the extra funds will be directed either back at Draghi’s own try-line (that is, into the core with all that this might imply for the TARGET2 system) or they will be directed off the pitch into overseas markets.

At this point, we can only hope that not too much of this extra money will flow out of the Euro and into the USD since these could prove inherently destabilising for the global financial system. Unfortunately, what has been noticeable over recent months is that any policy easing tends to act more on the external value of a country’s currency than perhaps any other variables but, if this turns out to be the case with the ECB’s QE, then any rally in risk markets could well be short-lived. In summary, Draghi tossed a rather large ball onto the pitch but we are far from certain that it will be carried over the right line. If his actions do result in a further significant weakening in the Euro or in further stresses appearing within TARGET2, we would recommend that investors adopt a more cautious outlook with regard to risk markets but, in the near term, it may still be worth trying to eke out a little more from the QE rally.

Andrew Hunt
International Economist, London

Andrew Hunt International Economist London

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