Wednesday 21 August 2019

David Chance: 'More of the same from the ECB is not enough to deliver economic security'

The European Central Bank headquarters on the River Main in Frankfurt, Germany. Photo: Bloomberg
The European Central Bank headquarters on the River Main in Frankfurt, Germany. Photo: Bloomberg

David Chance

Mario Draghi's European Central Bank swansong saw him promise once again to use all of the tools available in his bag of monetary tricks to help the eurozone's ailing economy.

With the German and Italian economies stuck at a stall speed that is close to recessionary territory, and the looming threat of a damaging trade war with the United States and a chaotic Brexit on the cards, it was clear the ECB had to signal it was ready to provide new stimulus.

What is not clear, however, is whether pulling on the string of the same policy responses that saved the eurozone in 2012 will work in 2019.

After five years of insisting that inflation in the currency bloc would hit its target thanks to ultra-low interest rates and injecting €2.6trn into the financial system, a figure that is equivalent to almost eight times the size of Ireland's economy, consumer price rises are still mired at 1pc.

All in all, in the decade since the Federal Reserve launched bond purchases, long-term interest rates have fallen to historic lows and record amounts of bonds are trading with negative yields - even as debt issuance by governments, companies and financial institutions rose to an eye-watering 245pc of the world's entire economic output by 2018.

If part of the aim of the post-crisis economic policy toolbox has been to prevent the re-emergence of the financial risk-taking and easy money excesses that characterised the boom era, then you have to ask how companies whose credit ratings are not investment-grade account for 60pc of corporate debt, twice the level of 2008.

A nagging feeling that something is profoundly wrong with the world has not, however, stopped ECB officials from claiming that what worked in the past will work again, if only we try some more of it.

Newly minted ECB chief economist Philip Lane was out on the stump just days into his new job, lauding the bank's policies, saying "non-standard measures", its longer-term refinancing operations, quantitative easing, negative rates, and forward guidance had added 0.8 percentage points to growth, and 0.3 percentage points to inflation in the past year.

That is all well and good, but as the adverts remind us, past performance is no guide to the future.

When the ECB first launched QE in 2015, Greece was in default and market risk in the likes of Italy was threatening to rip the eurozone apart. Cue the bond purchases, and 10-year yields fell by 30-50 basis points in core countries, and by twice that in Italy and Spain.

Fast-forward to today and it is not clear why bond purchases are such a good idea. And for the likes of negative-yielding Germany and the Netherlands, restarting the purchase programmes may actually be harmful, as Frances Coppola, an influential economics commentator, noted recently.

"There is no evidence that these countries would use that opportunity to borrow more to invest," she wrote in her blog.

"They are determinedly running fiscal surpluses and reducing debt issuance at all maturities.

"All ECB QE would do is help them reduce their debt even more quickly. This is not remotely productive."

Of course, with Italian bond yields still in positive territory and the government in Rome at risk of a fiscal doom-loop, yet more quantitative easing from the ECB would be welcomed by the financial markets.

However, the point about QE was to provide relief while governments fixed their finances, as they did here and in Portugal during the peak of the crisis.

It was not supposed to cause yields to fall as a result of financial repression that has, in effect, removed the potential threat of holding risky Italian debt.

For another example of the distortions induced by ECB policies, it costs Greece less to finance its debt over a 10-year period than it costs the United States.

Even when you factor out the currency costs for investors, the yield differential is well below the relative risk profile of the two countries.

The prospect of yet more to come on the money-printing and rate-cutting policies of the ECB has added to the queasiness of investors regarding banks.

The Euro Stoxx Banks index is down by a fifth in 12 months, while their return on equity is forecast to fall to 5.5pc this year, according to the ECB itself.

The price of bank shares reflects the cold economic reality that deposit rates for members of the public are stuck at zero and cannot move lower, whereas as ECB rates fall below zero, then so do the rates that banks can charge their customers. And the more lending you do, the less profitable your bank will become.

Under such a scenario, the ECB's actions would undermine their aims, as they would cut the supply of credit to the economy from banks, rather than boosting it.

One thing that the march to ever-lower rates does achieve, though, is to boost the rush for yield.

So banks will effectively be encouraged to take on more risk, chasing high-yielding bonds in financial markets, and creating the conditions for a new perfect storm in the markets.

Even the ECB acknowledges that the march to negative rates induces a 'hot potato' effect in debt markets among banks.

It also encourages capital to move out of the traditional banking sector, and into shadow banks and loosely regulated investment funds, who have gorged on assets like Irish real estate in a move that, if it misfires, will hit the economy here hard.

If there is a crumb of comfort to be had from all of this risk-taking, then it is that things won't be quite as bad this time when the music stops as in the last great crash, according to Dario Perkins of economic consultancy TS Lombard.

"The sub-prime crash was particularly deadly because the world's largest banks had leveraged themselves up to record levels using toxic collateral. When the value of these securities plunged, it triggered a nasty spiral of falling asset sales and forced deleveraging," he said.

"If the 'buy-side bubble' bursts, it would not have the same devastating macro consequences - though we would still expect a large decline in asset prices and probably a recession," he concluded.

The fact that it is not going to be a once-in-a-hundred-years crash just 10 years after the last one is scant comfort, as real people will once again lose their jobs and see their houses repossessed.

The very least the ECB owes the people whose livelihoods were destroyed 10 years ago is to try a new approach, rather than to rely on the narrow precepts of monetary policy that are quite clearly no longer up to the task.

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