With c€1.3 trillion in excess liquidity, and banks suffering from ZIRP, the ECB is likely to create more problems than benefits if it maintains its quantitative easing program.
Daniel Lacalle is a PhD in Economics and author of “Escape from the Central Bank Trap” (BEP), “Life In The Financial Markets”and “The Energy World Is Flat” (Wiley).
@dlacalle_IA
This week the European Central Bank has announced that it will maintain its asset buyback program, despite the fact that the European Union is neither in crisis nor in a recessionary shock. This is the first time in history that major central banks are making repurchases in excess of $200 billion a month without being in a period of crisis.
The European Central Bank launched a fresh defense of its monetary policy, saying that low interest rates and monthly asset purchases of €60bn have helped to stimulate growth and jobs in the eurozone and prevented the bloc from sliding into deflation.
“Our monetary policy was successful. The question is: is it time to exit or time to think about exit or not? This time hasn’t come yet,” he said. I am afraid he is wrong, ignoring financial risk accumulation and perverse incentives in over-indebted governments.
The growth figures of the European economy are good, and manufacturing indices are expanding. But they were already in expansion before QE was launched. The European manufacturing PMI is at six-year highs, the expected growth for 2017 will be 1.7% and 1.8% for 2018, unemployment will fall to 9.4% and 8.9% in 2017 and 2018 respectively, and growth of investment and credit is close to 2.5%. However, inflation by decree has been a failure, rising in energy and food prices and poor in core underlying inflation, a consequence of accumulated overcapacity and poor productivity.
You could say that these good growth figures are because of the ECB policy, but Europe was already expanding and recovering before they bought a single bond. Europe has been improving for five years. But that is not the debate. Even if we assume, for a moment, that the ECB policy has “worked” -despite 1.2 trillion euro of excess liquidity and high-risk bonds at the lowest rates in thirty-five years- the ECB must stop the monetary laughing gas urgently, for several reasons:
It runs out of tools before a cycle change. With zero interest rates, buying in some issues up to 100% of bond issues’ supply, and with new debt financing governments’ current expenditure and low productivity investments, whenever the economic cycle changes – and it does -, the central bank will have run out of its only historical tools.
After 600 rate cuts and buying tens of billions of dollars per month, it would create a boomerang effect that would generate more stagnation, Japanese-style. Anyone who thinks that the central bank can put negative types and increase money supply further and change everything is dreaming. What has not worked from 5 to 0% will not work from 0 to -5%. Financial repression does not lead agents to take more risk and invest, but to be more prudent, to hoard on liquid and safe assets, because monetary policy encourages over-indebtedness and perpetuates imbalances.
The ECB has already gone beyond the Fed. The ECB’s balance sheet already exceeds 36% of the Eurozone’s GDP and controls 10% of corporate bonds, a “nationalization” of the corporate debt market of almost 1% per month. In the case of the US, the Fed is c10 points below. Only the Bank of Japan surpasses the ECB, and we already know the level of debt and stagnation that the country has. The risk of following the path of Japan is not small.
It does more harm to the financial sector than benefits to the real economy. The bankruptcy of the zero-interest-rate policy is unprecedented and jeopardizes the consolidation process. Non-performing loans remain above 900 billion euros, operating margins and solvency ratios have plummeted to the lowest levels in a decade, and since the program was launched, Europe has seen three banking shocks, in Portugal, Italy, and even Germany. The impact on the financial sector is not compensated by the alleged economic improvement (a loss of almost 90 basis points in margins versus a slight increase of 15 in financial sector results, according to Mediobanca).
It does not help SMEs or families. While the ability to repay debt has not improved and cash or credit ratios remain poor, zombification of the refinanced sectors is soaring. High-yield is at the lowest interest rate in at least thirty-five years. Governments have saved more than 1 trillion euros in interest on the debt, of course, but, to my surprise, they have spent it all, and the ability of most European Union governments to adapt to an increase of only one 1% in the cost of debt is extremely low.
This leads to a rising tax burden despite the massive transfer of wealth from savers to governments, and – with it – it is extremely complex for SMEs and families to receive the slightest benefit of this extreme liquidity. Only 1% of SMEs have sought new credit, because their costs, excluding labor, have grown almost ten points more than their revenues, and of the meager 29% who requested a loan, only 69% received the required amount, according to the ECB. Despite extreme liquidity and low rates, demand for solvent credit remains very poor.
The huge risk of a bubble in bonds and financial assets is not offset by the supposed benefits of keeping the quantitative easing program. If we do not understand that accumulated risk is the root of the next crisis, we will repeat the mistakes of 2007.
Ignoring the risks that monetary policy generates in financial markets is very typical of central banks. It is thought that they can be mitigated, that they are acceptable and that they are not dangerous. And they are. They will be. Getting used to abnormally low rates and excessive liquidity to perpetuate imbalances is a huge risk. Not preparing for winter is suicidal.
Daniel Lacalle has a PhD in Economics and is author of “Escape from the Central Bank Trap”, “Life In The Financial Markets” and “The Energy World Is Flat” (Wiley)
@dlacalle_IA
Picture courtesy of Google
The French presidential elections have shown several evidences .
The second round will again put a moderate candidate, Macron , against a far-right one, LePen. This happened years ago between Chirac and LePen’s father … The big difference is that, then, the combination of extreme-left and the far-right did not add more than 40% of votes.
The euphoria of analysts ahead of a second round that concentrates the moderate vote in Macron cannot make us forget that the French society has reacted to the fierce and interventionist statism of Hollande increasing the support to more ultra-interventionist radicalism.
The disaster of the socialist party – pledging unicorns, making stimulus plan after stimulus plan and raising taxes over and over- has been spectacular. Not only has ultra-left-wing and ultra-right-wing populism not stopped, but Socialists have legitimized and fed it by repeating to citizens that the magic solutions of eternal expenditure and constant imbalances were viable. Between the diluted populism of Hamon and that of the totalitarians Melenchon or LePen, many prefered the original.
The decline of the center-right comes after many years of renouncing to its principles of free market and low taxes, surrendering to copy the Socialist party. This has made Fillon, besides the scandals, appear as not credible in its proposals of reform, among other things because he has been in high positions of responsibility and those same reforms were delayed to perpetuate the interventionism that he now criticizes.
Both Hamon and Fillon have requested their voters support for Macron in the second round, which leads to a high probability of a moderate victory.
What about Melenchon? The far-left candidate lost, but has refused to request the vote for Macron, proving that the extreme left candidate’s calls to defend France from the National Front were just political tactics. Melenchon’s economic policies are very similar to LePen’s.
The inability of traditional parties to respond to the real concerns of the people, including the terrorist threat and immigration, and their historic failure to implement reforms, has taken its toll .
When you make a race to see who is more socialist, it ends up backfiring and benefiting the one that promises unicorns.
Now the problem of France is to recover the dynamism lost in an economy that Macron himself described as “sclerotic” . There are many doubts about his true reformist agenda, evidenced by his actions when he has been minister. But we have to give him the benefit of the doubt. He faces a radicalized parliament, with traditional parties in disarray.
Reducing corporate tax, cutting labor costs, carrying out a labor reform similar to the Spanish one, and immigrant integration policies are part of Macron’s proposals, but we must wait to see if he wins the second round and if he has the support to implement them.
The challenge is enormous.
Just fifteen years ago, Germany and France had similar deficits and debts. Germany took the road of reforms and France the “ostrich policy”, ignoring its imbalances, attacking its own waterline with confiscatory tax and spending policies to sustain a hypertrophied public sector.
The last time France had a balanced budget was in 1980, and since 1974 it has never generated a surplus, public debt reached 96% of GDP, the economy has been stagnating for two decades, unemployment stands at 10% (with 23.6% youth unemployment ) and in 2017 it still has a current account deficit of 6.5 billion euros while the Eurozone has a surplus. Germany, on the other side, has a budget surplus, growth, much less unemployment (3.9%) and lower debt (71%). The French candidates have blamed the country’s problems on external enemies, from ‘globalization’ to ‘the euro’, however, comparisons with Germany destroy those arguments. It is hilarious to listen to LePen or Melenchon, the Ying and Yang of extremism, blaming France’s problems on “budget cuts” or “austerity . “
In a country where public spending exceeds 57% of GDP, where public administration spending has grown by more than 13% since 2008 and 22% of the active population works for the State, local governments and public entities, talking of austerity is a bad joke. In addition, France has spent tens of billions on ‘stimulus plans’ since 2009 . Specifically, 47 billion euro in 2009, 1.24 billion to the automotive industry and two ‘growth plans’ under the Hollande mandate: 37.6 billion euro (‘investments’) and 16.5 billion (‘technology’).
Blaming the French stagnation on “neoliberalism”, “austerity” or “the euro” is like an obese person blaming his overweight on lack of more donuts.
The problem is economic “dirigisme” -interventionism-, which stifles the potential of a rich nation that should not be satisfied with having better economic data than the periphery of Europe. France should be compared to the world’s leading economies. The problem that the next president of France faces is that, repeating the mistakes of the past, the country will not regain the dynamism of a nation that should not be content with secular stagnation and perpetuating imbalances.
Unfortunately, the results of these elections have shown us that a large part of the electorate thinks that “dirigiste” socialism has not worked because the country needs a lot more of it. A large part of the electorate prefers to believe that two plus two add up to twenty-two and that they will be richer if they take more money from those who produce to give it to those who do not.
Last night the European project may have won, and many will be relieved, but this cannot make us forget the most important thing: Legitimising the populist message is not the way to combat radicalism. It fuels populism.
Daniel Lacalle is a PhD in Economics, fund manager and author of Escape from the Central Bank Trap (BEP), Life In The Financial Markets, and The Energy World Is Flat (Wiley).
Image courtesy Google
Last week, the Federal Reserve announced three rate hikes in 2017, and another three in 2018, with a $600 billion reduction in its balance sheet ($420 billion in treasuries and $ 180 billion in mortgage-backed assets).
The announcement has sparked the concern of inflationists and bubble defenders. A downsizing of the Federal Reserve’s balance sheet! Anathema. As if it had not risen from $900 billion to the terrifying figure of $4.5 trillion, and mainstream analysts are worried about a small decrease. None of them seem to worry about the huge bubble in bonds nor the excess of risk taken looking for a little yield.
Mainstream is so concerned that they have invented a direct correlation of the size of the Fed’s balance sheet to warn of a massive crash in the markets… Except it does not happen. Rates are rising, the dollar is strengthening, the Fed’s balance sheet is shrinking… and stocks are soaring.
Stocks soar because earnings are better, leading indicators improve and financial conditions strengthen, not only because of money supply. Quantitative easing generated inflation on financial assets, while dividends and buybacks created multiple expansion, and now earnings are back to the rescue.
What consensus is worried about is that, between 2017 and 2018, the composition of members of the Federal Reserve will change to a majority that defends sound money, that is, to end the assault on savers and the middle class that QE meant. In the past eight years, fiscal policy in the US has meant an increase in taxes of $ 1.5 trillion and destroyed a similar figure in the value and purchasing power of the main source of wealth of the United States citizen: deposits. The largest transfer of middle-class wealth to the government seen in over fifty years.
The Federal Reserve is already almost 300 basis points behind the curve. It should to have raised rates much faster.
Meanwhile, in Europe, the ECB is not just behind the curve. It is so far away it does not see the curve.
If the ECB continues with its monetary policy while normalization accelerates in the US, the vacuum effect will multiply.
What is the “vacuum effect”? The world’s US dollar supply shrinks as demand for the currency soars, generating capital outflows in countries that are not a global reserve currency and into the US. This vacuum effect, added to the repatriation of dollars from US companies, is a major risk for the European Union. With more than 1.3 trillion euros of excess liquidity in the ECB, the EU would face the opposite scenario. Supply of euros massively exceeds demand.
Some will say it is an opportunity to export more. It just does not happen. European exports outside of the Euro Zone have stalled since the ECB started its quantitative easing program. But what does happen is that international confidence in risky assets denominated in euros diminishes. If it also coincides with a deterioration of solvency indicators – deficit, net issues, interest payments over GDP – this deterioration in confidence can generate a significant risk that, today, few are analysing.
We must remember that the vast majority of global trade transactions are made in US dollar (87.6%, according to the BIS).
Contrary to what many people think, the percentage of global transactions in US dollars is not only high, but has recently risen. In the same period, since 2008, transactions in euros have fallen eight points. It is no coincidence that this collapse in the use of the euro in global transactions, accelerated with the so-called “monetary expansion”.
As we mentioned, the euro risks losing relevance in global trade, and the alleged “export-effect” is inexistent. If the United States finally puts the policy of defending sound money and the savings of its citizens as the center of its policy, it can create enormous uncertainties for a euro that is now used in fewer transactions globally.
You will say that the US cannot survive a strong dollar, but we already dismantled that argument here (“Is the US dollar the new gold?”).
Almost all governments and parliaments in European countries are seized by the single thought the Japan-style futile policy of negative real rates and excess liquidity must continue, despite evidence of the risks it generates, but Japan has huge savings in foreign currency and an enviable financial inflow. The European Union, does not.
If the ECB resists raising rates, when it is an emergency, and reducing asset repurchases, when it has 1.3 billion euros of excessive liquidity, there could be significant risks in a global economy where the euro is an anecdote. If this is a risk with a strong currency, backed by economic powerhouses, imagine what would happen with unsupported currencies, as the European populists want. A disaster.
If we forget the need to strengthen economies before monetary excess ends, the negative consequences will be serious. Of course, when a new crisis arises, some will blame lack of regulation, not reckless policy.
Daniel Lacalle is a PhD in Economics, fund manager and author of Life In The Financial Markets, The Energy World Is Flat (Wiley) and Escape from the Central Bank Trap (BEP).
Image courtesy Google Images