The European Central Bank has rung the bell on the last act for both paper currencies and for modern central banks.
ON 22 January, Mario Draghi, the President of the European Central Bank (ECB) announced a new programme of asset purchases. This is not the first time that ECB will be buying debt securities. However, this will be the first time it will be buying sovereign bonds issued by member countries of the Euroarea. The amount of monthly bond purchases, including the purchases being done under the existing programme, will be €60 Billion. Those who are interested in the details can refer to the website of the ECB. The programme will run at least up to September 2016 with the announcement leaving room for further extension.
This is more about QEE and less about QE
The market thinks that the ECB is serious and that it amounts to a credible currency debasement. The EURUSD exchange rate has dropped from 1.16 to around 1.13 as I write this. The market is right to believe that the ECB President is serious about debasing the single currency. The following sentence in his introductory remarks at the Press Conference is a plaintive cry to the market to weaken the Euro:
“… today’s decisions will support our forward guidance on the key ECB interest rates and reinforce the fact that there are significant and increasing differences in the monetary policy cycle between major advanced economies…”
So far, the market is helping. The Euro has weakened. Cut through the rhetoric, the expanded asset purchase programme is actually all about weakening the currency. It is a “beggar thy neighbour” policy. Last April, at the Brookings Institution, Raghuram Rajan, the Governor of the Reserve Bank of India, made a speech in which he said that QE (Quantitative Easing) was nothing but QEE (Quantitative External Easing). Draghi’s anxiety to draw the attention of the market to the diverging monetary policy stance between the Eurozone and, say, the United States, is nothing but an attempt to push the Euro down against the US dollar. This validates the point that Rajan made that QE was nothing but QEE something that the West took exception to, when Asian countries followed such an approach.
Will QE help or is it needed?
Whether it is QE or QEE, the question, as always, is whether these measures would help revive economic growth in the Eurozone and improve employment prospects. Let us examine the QE aspect of the ECB announcement, first. We start with his confession:
“… Second, while the monetary policy measures adopted between June and September last year resulted in a material improvement in terms of financial market prices, this was not the case for the quantitative results…”
He acknowledges that the measures launched last year have boosted asset prices in financial markets but done little else. If anything, Eurozone economies slid further into recession and a possible deflation. That should make sensible people wonder if they have been administering the wrong medicine to the patient. But, the policy czars at central banks in the developed world are cut from a different cloth. If the medicine proved ineffective, their only answer is that the dosage must be increased. If one or two spoons of the medicine do not take effect, then the patient must down one bottle each time and to hell with consequences and side effects. All that it would do is to widen the chasm between economic fundamentals and asset prices with unpredictable consequences.
In his introductory statement, the President of the ECB laid great stress on fighting deflation. In fact, deflation disappears if we examined core CPI inflation in the Eurozone. Core consumer prices rose (all items ex-energy) 0.6 percent y/y in the Eurozone in December 2014. That is reasonable for the Eurozone economy considering that it is in recession (or almost) with high unemployment in many countries. Really, the data does not suggest any urgent need to fight deflation here with a monetary expansion programme. Consumer price deflation at the headline level is mainly due to the collapse in the price of crude oil. That should already translate into an economic stimulus for Eurozone consumers. They did not need additional stimulus. Actually, the weaker Euro offsets the advantage of consumption stimulus from the oil price plunge.
Further, Draghi spoke of the need to support money and credit growth in the Eurozone. Do Eurozone sovereigns really need a lower interest rate? As things stand, yields on the 10-year sovereign bonds issued by Italy and Spain (around 1.5 percent to 1.6 percent) are lower than that of the yield on the US 10-year Treasury note (around 1.8 percent). France and Germany have even lower yields. Investors are, for reasons best known to them, willing to lend money to Italy and Spain at these yields. Hence, cost of capital does not appear to be a deterrent either for Eurozone sovereigns or for willing non-sovereign and non-financial borrower. After all, interest rates are already close to zero in the Eurozone.
If, in spite of the ultra-low interest rates, European banks are not lending to non-financial corporations and households, it could be due to one of the two reasons or both. One there is no room in their balance sheets to take on further debt. Two that they do not see a justification to take on more loans – in other words, that there are no growth opportunities.
There is enough evidence to believe that both are true. Leverage ratios in the Eurozone have only increased post-crisis. According to a report published in September 2014, the leverage ratio (excluding financials) of government and private sector debt in the Eurozone amounted to 257 percent of GDP. This was about 25 percentage points higher than the level in 2008. It is evident that de-leveraging has not been the problem behind the sluggish growth in the Eurozone. Even if de-leveraging were happening, it would be a good thing for balance sheets to return to health so that borrowing and investing could resume sometime in the future. It is clear from the ultra-low bond yields in the Eurozone and from the rise in the leverage ratio that the Eurozone is unlikely to benefit from the reduction in bond yields arising out of ECB asset purchases.
As for the second reason, Summers and Pritchett make such a strong pitch for economic growth rates in China and in India to slow in the years ahead. The world economy and Eurozone, in particular, will be no exception. Global growth rates have been exceptionally high in the last quarter to half century. It has been due to many factors – post-War reconstruction, technological advancement and productivity, globalisation, the rise of India and China and, more importantly, the rise of global indebtedness. Leverage has boosted growth. If payback time has arrived for India and China, as Summers and Pritchett argue, then why would it make an exception for the Eurozone with far worse demographics?
In sum, interest rates are already low; the Eurozone had added to its debt burden in recent years and global economic growth has just embarked on a structural slowdown. So, what would the ECB achieve? Asset bubbles, inflation down the road and, in the near-term, beggar-thy-neighbour from other countries. China is the prime candidate to follow the ECB next.
China to follow
Let us turn to the QEE aspect of the ECB announcement. The Euro has weakened against the US dollar and against other currencies, surely. As I write this, EURUSD is almost down to 1.10. Will it help the United States? The US believes that its economy is in good health and that it can absorb a strong currency. We are not sure. We have always been and remain sceptical of the US economic strength or resilience. In fact, at the margin, the ECB decision strengthens the case for the Federal Reserve to desist from any rate hike this year. Furthermore, it might even have to resort to QE4 in the second half of the year.
The bigger impact will be on China. It announced a GDP growth rate of 7.4 percent for 2014. However, the International Monetary Fund has downgraded its growth forecast for China to below 7 percent for 2015 and further lower in 2016. Even the 7.4 percent GDP growth number has come under intense scrutiny from an independent economist:
“Growth in narrow money M1 has collapsed. It was a dangerously excessive 32.4 per cent in 2009. It was a dangerously anaemic 3.2 per cent in 2014. M1 is money being held ready for use in anticipated transactions. It should correlate very well with GDP, which is a sum of transaction values. But, while M1 flies around over time, GDP growth barely budges in comparison. It strains credulity that the amount of money held for use could grow at one-tenth the speed in 2014 as it did in 2009, yet growth in uses of that money (GDP) drops less than 2 points.”
Further, China’s unemployment rate has hardly budged in the last twenty years while GDP growth has considerably decelerated. That too defies explanation. They hardly match with import numbers from destination regions or areas (e.g., Hong Kong). In short, China’s macro-economy is not a picture of good health. Its export numbers are distorted by hot money inflows.
The weakness in the Euro will take away export market share from China in third countries and reduce the attractiveness of Chinese imports for Eurozone customers. It will also make it costly for Eurozone manufacturers to step up investment in China. If anything, China might have to look for growth by investing in Eurozone nations with a weaker Euro facilitating it.
Hence, the real risk is that China’s growth rate falls not just to 6.8 percent from 7.4 percent as the IMF foresees but much more. In that event, what will China do? It cannot sit by and watch passively as Japan and the Eurozone take market share away from it. Hence, the ECB decision of January 22 has narrowed the odds on a maxi China monetary policy move considerably. Next to follow will be Korea; then, India (with deep rate cuts) and Indonesia.
That is why we feel that the ECB might have set off the economic equivalence of World War III. Of course, it might claim that it all started with the United States in 2009. That would be a very fair point.
In the short-term, this will buoy asset markets. Stocks everywhere will set new records or perform far better than their fundamentals could ever justify (e.g., China markets). However, a spectacular crash will be lurking. There should be no doubts on that. The stark truth is that curtains have been lifted on the grand finale to fiat money (paper money) managed by unaccountable technocrats. The ECB has rung the bell on the last act for both paper currencies and for modern central banks. In time to come, we will be grateful to the ECB for that.
Even a student of high-school economics will declare Gold to be a screaming buy in these circumstances.
Photo: Sean Ryan
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