Wednesday, 7 May 2014

QE or not QE? – German nightmares haunt the ECB as it tries to create growth

In 1922, a German couple decided that the new government of the Weimar Republic was not creating the right environment in which to bring up their children, and that they would move the family to America. So they sold their house and set off with all their worldly possessions. But when they arrived at the port town of Hamburg, they were told that the money from the sale of their house would not be enough to cover the cost of the voyage to America, and in fact it would no longer even be enough to get them back home. Such was the speed with which money depreciated in the hyperinflationary environment of Germany in 1922-23. This period of German history has haunted the national consciousness of Europe’s dominant nation ever since, leading to an exceptionally cautious monetary ethos. But recent low growth has led economists to speculate that a more urgent danger is of the Eurozone slipping into deflation, pointing at the cautionary example of Japan after 1990.

In order to understand European monetary policy it is necessary to look at the history of money in the region. Until the advent of the First World War, the currencies of Western Europe were tied to the price of gold; this provided very little scope for inflation. As the costs rose in the great war of attrition, the various nations ran up massive debts in their attempts to pay them. One by one they turned to the printing press for a solution to their financial needs, abandoning the gold standard and printing large quantities of money, sending inflation soaring; this was particularly true in Germany and France. As Thomas Picketty writes in Capital in the Twenty First Century, “between 1913 and 1950 inflation in France exceeded 13% per year....inflation in Germany exceeded 17% per year so that prices rose by a factor of more than 300”. This experience created in France and particularly Germany a deep aversion to inflation and ‘racier’ monetary instruments, and the Deutschmark subsequently became a bastion of stability after it was established in 1948. When Germany and France created the Eurozone in 1999, it was, according to Picketty, based almost entirely on the principle of combating inflation”.

Up until the present day, the ECB has been following traditional policies to stimulate growth. Interest rates have dropped to almost zero (0.25%), and the central bank has been resisting temptation to join its Anglo-Saxon peers on the quantitative easing bandwagon. But inflation rates in March were just 0.5%, substantially below the target of 2%, and even though April’s minimal rise to 0.7% has taken the pressure off slightly, another drop in May and storm clouds will begin to gather again.

So what are ECB Head Mario Draghi’s options? He could choose to bluff, to undertake QE, or to experiment with negative interest rates:

1)      The Bluff – in this course of action, Draghi makes the market believe that he intends to implement QE, whether or not he actually does intend to. Last month, Draghi made a show of publicly discussing the possible ways in which QE could work. As we have seen in the Eurozone over the past five years, sentiment can be just as important as fact, and the belief that QE is imminent could be almost as effective at changing behavior as actually implementing it. Rather like a sheepdog, he manipulates the flock merely by his positioning. One problem with this course, however, is that Draghi has already done it once before – his claim back in 2012 that the ECB would do “whatever it takes” to prevent the Eurozone from collapse meant that the fraught situation resolved itself without him having to spend a cent. The question is whether words will always be enough, or if the market will one day call his bluff. Even the most effective sheepdogs sometimes have to nip the odd leg to be taken seriously.

2)      Undertake QE – This course is littered with obstacles:
a)      Germany. As explained above, Germany has a longstanding mistrust of racy financial instruments, especially ones which involve printing money. In addition, recent crises in the European periphery have hardened the German position against any kind of financial re-distribution. A German court recently took the controversial step of analyzing whether a 2012 ECB bond-buying policy (named OMT) had been illegal under Eurozone rules; it ultimately returned a disputed verdict and referred the case to the European Court of Justice. Though the head of the ECB is Italian, the Germans command a great deal of influence due to their political and financial clout in the Union.

b)      How to do it? The US, UK and EU economies are all differently structured. Before you decide to implement QE, you must first work out how it will be done.  In order to stimulate growth you want to place money into the hands of companies themselves, which they will then be able to invest into their own development. The most obvious way to do this, buying shares or bonds in the companies, is unsatisfactory since it leaves the state holding a direct stake in a proportion of its own market. Thus the location of the money injection becomes key.
In the US, companies receive their funding largely from the open market in the form of corporate bonds, so the American challenge was to drive investors into buying these. This was achieved by buying US government bonds which thus drove down their yields, and had the double effect of lightening the government debt repayment burden and driving investors out of the now unprofitable sovereign bonds. Starved of yield in their safe havens they were forced to buy the riskier corporate bonds.

The ECB would struggle to copy the US’s QE policy, in the first place because there would not be one clear sovereign bond to buy, since the eurozone is made up of many different sovereigns. Additionally, if the ECB did start buying sovereign bonds in the periphery it would alleviate some of the financial pressure on those governments; this would be counter-productive since it is that very pressure which has been driving reform in Portugal, Spain and Greece.  The European economy is dominated by small and medium-sized companies (SMEs), which are often too inconsequential to have a corporate bond underwritten by their assets. The debt of several of these companies can however be pulled together into a tradable ‘Asset-Backed Security’ (ABS), which would be an ideal market for the ECB to invest in if it wanted to stimulate SMEs. Unfortunately, the ABS market is much smaller in Europe than in the US, and lacks the prerequisite depth to be able to have a significant effect on the bigger picture. In fact, EU companies actually tend to receive their funding from banks, and this is where the added complication comes in. After the crisis it was decided that Europe’s banks were undercapitalized; that is, they did not have enough money held in reserve in case of disaster. New regulations require that banks raise their capital levels, which is a process that is currently under way, and is partly responsible for the lack of loans to the SMEs which caused the low growth in the first place. If money were to be given to banks to encourage them to lend more, there is a danger that it would just be absorbed into their new larger pools of capital, and would never make it through to the companies themselves.

For these reasons it remains very unclear as to how the ECB would be able to efficiently undertake quantitative easing. When this is taken alongside German resistance to experimentation, it becomes an extremely unlikely course of action given the current circumstances.

3)      Negative Interest Rates – With interest rates currently at 0.25% and the deposit rate at 0%, there is not much further the ECB can go within conventional monetary policy, but continuing through zero and into the minus figures is a course of action which does have a precedent. A negative rate on the Deposit Facility would mean that banks would find themselves actually paying interest for the privilege of keeping money with the central bank, the aim being to incentivize them to do something more productive with it. This policy was adopted in the 1970s by Switzerland, when it was trying to reverse a surge in its currency price in the wake of the OPEC Oil Crisis, and by Denmark in 2012 under similar circumstances, but it has never been attempted by a major global economy. One worry is that banks will simply pass this extra cost onto their customers, providing the complete opposite effect to that which was intended. Once more, if there is to be a pioneering maneouvre in monetary policy, it is unlikely to come from a central bank that is heavily influenced by Germany.

The German-dominated ECB remains unlikely to pursue any course which might be considered reckless or untested, with the Euro being treated very much like the Deutschmark that preceded it. The difference of course is that the Deutschmark represented the finances of one relatively homogenous country, while the Euro is the currency of an experimental union of widely varying economies. Are the tried and tested methods sufficient to maintain a successful Eurozone? Time will tell. But the example of stagnant Japan between 1990-2012 confirms that the dangers of deflation should not be taken lightly.

Appendix – Japanese example

To some, the Japanese experience might not seem that bad. The so-called ´lost decade´, which began in 1990 and has ultimately stretched to over twenty years, has been a period of low growth and stagnation (an economist´s nightmare), but to the man on the street the idea of getting richer every day, as prices decrease, might actually sound quite appealing. Japan has not been hit by famine, disease, or any other side-effects associated with poverty, it is still the world´s third largest economy and quality of living is high. The problems, such as they are, bubble under the surface, and have been growing continuously. Over the last twenty years Japan has been steadily accruing government debt, to the point that it is now the most indebted country in the world (when viewed as a percentage of GDP). The reason it has not suffered greatly from this growing burden is that it has been paying very low levels of interest on the debt, as a result of strong investor confidence and high demand for its bonds. The end to this benevolent arrangement comes when faith starts to waver, and investors begin to sell their government bonds; at that point Japan finds itself paying a rising yield on a giant debt pile, and the subsequent financial problems undermine the confidence of remaining investors, creating a self-perpetuating downward spiral. Something had to change before this tipping point was reached, and President Shinzo Abe has emerged with a risky plan. His ´three arrows´ strategy involves stimulating the dormant Japanese economy with quantitative easing, and making structural changes to create the growth which can begin to shrink the Japanese debt. If this strategy succeeds, Abe will have hauled Japan out of its ever deepening hole; if it fails, he might have created the low-confidence tipping point he was trying to avoid, or perhaps inflation will career out of control, the risks are very significant. This strategy is uncharacteristically reckless, but the Japanese have been driven to it by their earlier complacency.