Challenging read - QE, exchange rates, dilemmas

 

ECB adds another half trillion in QE, even as Italy eyes debt cancellation

The central bank is in effect holding the fort through the worst of the crisis and shielding vulnerable states from markets until late 2021

ByAmbrose Evans-Pritchard 10 December 2020 • 10:07pm

The European Central Bank has stepped up pandemic emergency stimulus by another €500bn to counter a double-dip recession, but stopped short of ‘shock-and-awe’ measures to reverse a corrosive slide into deflation.

Bond purchases will be stretched out to 2022,  clearing the way for the ECB to mop up three quarters of all fresh debt issuance by eurozone governments next year. This further obliterates the line between fiscal and monetary policy, and pushes the ECB’s balance sheet beyond 70pc of GDP. 

The central bank is in effect holding the fort through the worst of the pandemic and shielding vulnerable states from the markets until the EU’s €750bn Recovery Funds starts to feed through in late 2021. 

The package of measures amounts to Japanese-style "yield control", sending a message to markets that the ECB will hold down long-term interest rates across the board and for the foreseeable future, regardless of underlying credit worthiness or moral hazard. 

The policy was signalled weeks ago and has set off a speculative ‘convergence play’ as funds rush to buy southern European debt and reap quick gains on capital appreciation. 

“The ECB is telling us that their job is to keep borrowing costs as low as possible and these bonds are an absolutely safe investment. We’ve never had that kind of explicit message before,” said Marchel Alexandrovich from Jefferies. 

Yields on 10-year Spanish bonds touched zero for the first time on Thursday. Italian bonds were trading at negative yields on maturities out to five years, even though Italy’s debt has rocketed to nosebleed levels of 161pc of GDP this year and the country is implicitly insolvent.

Professor Moritz Kraemer from Frankfurt’s Goethe University said the ECB has already pushed QE long past the point of diminishing returns and that further purchases will gain little economic traction. “Its strategy has stopped stimulating credit and demand. The only thing that it is achieving now is pushing yields even lower and blowing bubbles,” he said.Any benefits may be overwhelmed by the surging euro, which is fast turning into a terms of trade shock . The trade-weighted euro index has jumped 7pc this year and is flirting with an all-time high.

This is vastly complicating the ECB’s attempts to stave off deflation, with all the destructive pathologies that come in its wake. Headline inflation has dropped to minus 0.3pc and core prices may go negative over the winter. 

Christine Lagarde, the ECB’s president, said the bank is monitoring the exchange rate “very carefully” but attempts to talk down the euro are likely to fail.

The ECB lacks the tools to fight appreciation in the face of a structural bear market for the US dollar and other currencies linked to it, directly or indirectly, including the Chinese yuan. Europe risks being the region that ends up holding the unwanted parcel that everybody else manages to pass on.

Frankfurt resisted the temptation to cut interest rates further below minus 0.5pc, knowing that Washington would deem this to be thinly-disguised currency manipulation. The Bank of Japan was warned in harsh terms when it tried to play this game.

In any case, negative rates have serious side-effects and erode the bread-and-butter business model of banks. The ECB has sought to blunt this with a technical device known as ‘tiering’ and has now extended ultra-cheap loans to commercial lenders at rates of minus 1pc for another year.  

Nevertheless, there are signs of an incipient credit crunch in Europe as the delayed effects of the Covid recession become apparent and moratoria expire. Banks have begun to choke lending. They are demanding more collateral to protect themselves from a cascade of defaults. 

The European regulator warns that bad debts in the banking system could hit €1.4 trillion, dwarfing the damage from the global financial crisis in 2008 and leaving many lenders under water.

The ECB’s blanket of QE has bought time but it has also made the system inherently more unstable. It has induced banks to feast on eurozone sovereign debt, two-thirds of it issued by their own national governments. Holdings have surged by €400bn this year to a record €1.86 trillion.

The unresolved ‘doom-loop’ of sovereigns and banks - each dragging the other down in times of stress  - is now bigger than ever. EU leaders vowed eight years ago to sort out this systemic design-flaw but lost interest after the debt crisis faded. They never completed the banking union and there is still no pan-EMU deposit insurance. 

The ECB is in an invidious position. It cannot easily stop buying Club Med bonds without risking a financial chain-reaction. Italy, Spain, or Portugal could turn to the EU bail-out fund (ESM) for support in extremis but they would not do so lightly given the conditions attached. Any move to push Italy into this sort of troika regime might destabilize the current pro-EU government and set off fresh calls for a return to the lira.

For now Germany is going along with ever more QE. It has reshuffled €140bn of its own internal debt to make the latest move easier. This sleight of hand allows the ECB to keep buying more bonds without deviating so visibly from its sacred capital key. 

While the details are abstruse, the political signal is not. Chancellor Angela Merkel has clearly opted to let the ECB continue carrying the load for the whole EMU system - faute de mieux -  even if that stores up large problems for the future. 

However, it is an open question whether this implicit strategy will pass muster at the German Constitutional Court - or the anti-elite  ‘people’s court’, as the chief justice called it after its last thunderous ruling against QE.  

There is a strange dissonance to extra bond purchases at a time when Italian leaders and politicians are calling ever more loudly for cancellation of the ECB’s existing holdings. Demands for debt forgiveness on pandemic QE come from across the political spectrum, including close aides of premier Giuseppe Conte. 

Matteo Salvini’s Lega party says the digital debt is an accounting fiction and should be wiped clean with the click of a mouse. The European Parliament’s Italian president David Sassoli is flirting with the idea. The demands have reached the front page of Avvenire, the voice of the Italian Catholic bishops’ conference.

Holger Schmieding from Berenberg Bank said the concept is lunacy and would backfire horribly. “People calling for this either don’t understand what they are asking for, or there is really something else behind it, and that is what could set off a run on the debt markets,” he said.

Legally and technically, it is the Bank of Italy that would be on the hook for most of the €550bn of Italian debt bought under the various QE schemes, not the ECB as such. One branch of the Italian state would therefore be forgiving another branch. The Italian treasury would have to issue extra debt to recapitalize a bankrupt Bank of Italy.    

Mr Schmieding said investors would see the gambit as a “trial run for a broader debt restructuring at their expense”. Risk spreads would soar and Southern Europe would be thrown back into a debt crisis.

For Italy, such a radical move would make sense only if it was part of a much larger debt restructuring and a lira redenomination. That would entail a partial default by the Bank of Italy on its €520bn of Target2 liabilities to the ECB under the principle of Lex Monetae. This would be a financial earthquake for Europe and the world. 

For the time being, the ECB is doomed to keep sinking deeper into this debt trap even though everybody knows that QE has become a disguised monetary bail-out for insolvent states. In other respects it probably has no more economic potency at this juncture than a rain dance.

A smart look at the European banking system

This article from mises.org looks closely at issues in the EU banking arena. It contains some key concepts, and is highly relevant to policy, particularly monetary policy. There is a new emphasis on finance, and this looks at ways banking affects economies, and references the work we have done on credit cycles. Note that Europe is quite different to the UK and the US, as firms rely heavily on banks for loans in the EU, whereas the UK & US use bond markets far more. This means EU banks are huge, but suffer exponentially in downturns. Mises.org is an academic institute named for Ludwig von Mises, a leading Austrian economist. "Austrian" is a school of economics, as is Keynesian economics. Friedrich von Hayek is the best known Austrian economist, and is recognised as a major free-market thinker. Remind me to bring this up when we do monetary policy.

Deutsche Bank's Troubles Raise Worries About the Future of the Euro Zone

• 

06/19/2018 Thorsten Polleit

The euro banking sector is huge: In April 2018, its total balance sheet amounted to 30.9 trillion euro, accounting for 268 per cent of gross domestic product (GDP) in the euro area. Unfortunately, however, many euro banks are in lousy shape. They suffer from low profitability and carry an estimated total bad loan exposure of around 759 billion euro, which accounts for roughly 30 per cent of their equity capital.

Share price developments suggest that investors have lost quite some confidence in the viability of euro banks’ businesses: While US bank stocks are up 24 per cent since the beginning of 2006, the index for euro-area bank stocks is still down by around 70 per cent. Perhaps most notably, ’Germany’s two largest banks, Deutsche Bank and Commerzbank, have lost 85 and 94 per cent, respectively, of their market capitalization.

With a balance sheet of close to 1.5 trillion euro in March 2018, Deutsche Bank accounted for around 45 per cent of German GDP. In international comparison, this an enormous, downright frightening dimension. It is mostly the result of the bank still having an extensive (though not profitable) footprint in the international investment banking business. The bank has already started reducing its balance sheet, though.

Beware of big banks — this is what we could learn from the latest financial and economic crises 2008/2009. Big banks have the potential to take an entire economy hostage: When they get into trouble, they can drag everything down with them, especially the innocent bystanders – taxpayers and, if and when the central banks decide to bail them out, those holding fiat money and fixed income securities denominated in fiat money.

Banking Risks

For this reason, it makes sense to remind ourselves of the fundamental risks of banking – namely liquidity risk and solvency risk –, for if and when these risks materialise, monetary policy-makers can be expected to resort to inflationary actions. In fact, to fend off these risks from materialising, central banks have committed themselves to pursuing chronically inflationary policies.

Liquidity risk describes the risk that a bank might fail to meet its credit obligations in full. This is an inherent risk as most banks extend long-term loans and refinance themselves with short-term funds. As a result, they have to succeed in rolling-over maturing debt. In a situation in which investors are no longer willing to lend their money, the banks may not be able to obtain new funds and become illiquid.

However, in today’s fiat money system, central banks are in a position to print up any amount of base money at any given time, and they can lend this newly created money to ailing banks at their discretion. As a result, the liquidity risk can be, and actually is taken care of by central banks. A single bank may go under due to a lack of liquidity. But not the banking system as a whole, as in a liquidity crisis, central banks can, and do, decide to prop up the system.

Solvency risk means the risk that banks’ assets are not worth enough to service banks’ debts. It can strike if and when losses on loans make a bank’s incoming cash flow drop below its cash outflows. A bank may well continue to operate for quite a while despite being insolvent: It meets its daily payment requirements because cash outflows remain below the total that will become due at some point in time.

Keep the Fiat Money System Going

If and when insolvency makes liabilities exceed its assets, however, a bank’s equity capital is wiped out, and the bank may even default on its debt, and savers and investors lose their funds. While it is relatively easy for a central bank to prevent a liquidity crisis in the banking sector, it is quite another matter when it comes to an insolvency crisis: Once asset values start falling and losses are getting realized, problems reach a new dimension.

If banks in such a situation fail to raise new equity capital, the government – fearing a collapse of the banking system – typically steps in. It either uses taxpayers’ money to provide banks with new equity capital, or it can issue new debt, which is bought by the central bank against issuing newly created base money, with the latter being paid in as new bank equity capital – and the affected banks being taken over by the government.

In reality, central banks and governments have put a ‘safety net’ under the banking industry. Smaller banks may well go under, but a scenario in which the entire banking system goes belly up will be prevented for a simple reason: Politically speaking, the costs of a fiat money system collapse is simply too high and has to be prevented; no price is viewed as too costly to keep the fiat money system going.

A Vicious Circle

This is what sets a truly vicious circle into motion. For today’s fiat money causes booms which sooner or later must turn into a bust. The liquidity risk and especially the insolvency risk can be expected to hit the banking industry at some point. To prevent it from materializing, the central bank must keep expanding the quantity of (base) money and keep interest rates at artificially low levels, keeping the inflationary scheme going.

Central banks sow the seeds of crisis, and once the crisis unfolds, especially when it affects banks negatively, central banks run bailouts by injecting new money provided at artificially low interest rates, and the vicious cycle starts all over again. Needless to say that such a cycle causes economic and social problems on a grand scale. It makes the purchasing power of money drop. Only a few benefit, while the majority of the people is taken advantage of.

Given the problems of the euro area banking industry, we should indeed wonder what might happen next. The scenario that the euro area economies might grow out of their banking problems would undoubtedly be a rather convenient one, but it is fairly unlikely. Bailing out ailing banks with taxpayers’ money and an inflation-financed recapitalization of banks’ equity capital might be a much less pleasant scenario, but it appears to be more likely.

For one thing is indisputable: If an oversized banking apparatus starts to shrink, the outstanding stock of credit and money will decline. And as the quantity of money goes down, prices across the board trend downwards causing deflation. Needless to say that deflation is a nightmare for highly indebted economies: Falling prices increase the real debt burden, sending the financial and economic system into a cataclysmic downward spiral.

Inflation Is a Policy that Cannot Last

The current president of the European Central Bank (ECB), Mario Draghi, said in July 2012: “[T]he ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” Taken at face value, these words suggest what the ECB is ready to do: to print up ever greater quantities of euro balances to prevent the euro currency from falling apart. Ironically, however, this is precisely what the ECB’s money printing scheme will bring about.

Ludwig von Mises (1881 – 1973) noted in this context wisely: “All governments are firmly committed to the policy of low interest rates, credit expansion, and inflation. When the unavoidable aftermath of these short-term policies comes to pass, they know only of one remedy — to continue their inflationary ventures.”1 These words capture pretty well what has been going on in the euro area.

Without the ECB’s overly generous issuing of fresh fiat money, the euro banking apparatus could not have reached its current size, its bloated dimension. And with its attempt to rectify its inflationary policies of the past – namely preventing the euro banking sector from collapsing, the ECB is about to pursue even more extensive inflationary policies. This doesn’t bode well for the euro’s purchasing power going forward.

The euro area provides a textbook example of a rather unholy alliance between the central bank and commercial banks: It has not only caused an inflationary boom and bust cycle that has resulted in a severe financial and economic crisis. The unholy alliance has also made possible an oversized (and poorly performing) banking industry, and the policy to keep it going will result in a rip off of the majority of the people on a truly grand scale.

• 1. Mises, L. v. (1998), Human Action, Scholar’s Edition, p. 794.

Dr. Thorsten Polleit, Chief Economist of Degussa and macro-economic advisor to the P&R REAL VALUE fund. He is Honorary Professor at the University of Bayreuth.