photo: Chris Goldberg
Investors were disappointed when they undid the wrapping on the European Central Bank’s (“ECB’s) early holiday present.
The package was not insignificant: a cut in deposit rates by 0.10% from negative 0.20% to 0.30%; an extension of the €60 billion per month bond purchase program by six months (additional €360 billion in liquidity); a commitment to reinvest the principal repayments on its holdings in further bonds; and expansion of the range of securities to be purchased to include regional and local government debt.
But the market expected deeper rate cuts and acceleration of the rate of purchases. The ECB blamed markets for ‘over-hyping’ expectations. Markets blamed ECB’s recent guidance which promised more aggressive measure.
Shortly after the announcement, ECB President Mario Draghi found himself the subject of uncomfortable questioning from Lord King, the former head of the Bank of England against a background of derisive audience laughter. Asked why his famous ‘forward guidance’ had failed to move markets, the uncomfortable ECB president could only respond that the words did not have the same effect as his famous “whatever it takes” because “it was not the same words”.
In reality, the rise in Euro-Zone market rates and the Euro will reverse. The increase in US rates will help. Dr. Draghi’s backtracking and subsequent promise for unlimited quantitative easing (“QE”) will mollify investors temporarily.
But Dr. Draghi’s frequently repeated assertions of success notwithstanding, the necessity for the ECB’s new actions points to the failure of the policy to restore growth or raise inflation.
Europe did avoid a potential double dip recession in 2014. But economic activity remains weak. The Euro-Zone economy has lost momentum, expanding a mere 0.3% in the three months to September of 2015. Worryingly, Spain and Portugal slowed. Finland and Greece contracted. Italy and France remain weak. Real GDP remains below the level of 2008. Unemployment is around 10.7%, down from a high of 11.5%. It remains above 20% in many weaker economies. Inflation is near zero, although above the record low of -0.70% of July 2009.
The improvements are cyclical, the effect of low oil prices and the relaxation of fiscal policy as the European Commission has turned a blind eye to the failure by members to adhere to prescribed budget deficit targets. France and Italy in particular have openly flaunted budget targets. France even used the attacks in Paris to muse about invoking emergency or exceptional circumstances provisions to increase spending.
The ECB’s program has benefitted Europe primarily through the weakening of the Euro to improve competitiveness. But the improvement in European exports may be unsustainable.
First, weakness in emerging markets affects around 25% of Euro-Zone exports with the greatest effect on Germany, France, Italy and Spain. China’s slowdown and rebalancing towards services and consumption will be detrimental to European exports of capital goods. Second, the Euro-Zone has a current account surplus of 3.7% of GDP, the largest in the world. This is unsustainable because it is fuelled by insufficient domestic demand and high unemployment. It requires trading partners to run equally large current account deficits. Other nations are unlikely to accept European neo-mercantilism and continue to indefinitely absorb European surpluses.
ECB actions do not address crucial issues. Debt levels remain elevated and, in some case, are increasing. New lending has not recovered.
Lack of demand rather than liquidity limits new lending. In addition, euro interest rates for companies and households remain relatively high, around 2%, despite government and inter-bank rates being negative.
Another constraint is non-performing loans (NPLs) which total €1-1.2 trillion (9% of GDP), a doubling since 2009. NPLs are high in weak economies, such as Italy, Greece, Portugal, Spain and Cyprus, and concentrated amongst small and medium-sized enterprises (SMEs), responsible for two-thirds of Europe’s output and employment. The ECB’s measures are making the problem worse by allowing zombie companies that need to be restructured and debts written off to continue to operate. It is also reducing bank profitability, making it more difficult to write down NPLs.
Internal financial imbalances, evidenced by Target 2 balances, have begun to deteriorate. The fundamental problems of the single currency and uniform monetary policy remain unresolved. Finland is scheduled to hold a parliamentary hearing into continued membership of the Euro shortly. The British referendum on its membership of the EU is scheduled for 2017.
Despite Dr. Draghi’s insistence of the unlimited extent of his powers, the ECB is likely to face increasing constraints on its freedom of action. The recent weaker than expected actions in December 2015 may reflect divisions with the Governing Council, where German, Dutch and other members are known to oppose greater activism.
The ECB also faces practical limits. It will increasingly find it difficult to execute bond purchases as it runs up against its single issuer and concentration limits. The ECB can only purchase government and agency debt at negative yields above the deposit facility rate (currently minus 0.30%). With an increasing proportion of government bonds trading at ever lower yields, the available universe of bonds may shrink.
The ECB also faces external pressures. Negative deposit rates have triggered large capital outflows, around €500 billion, helping depreciate the value of the euro. This increases Euro-Zone exporters’ share of global demand. It does not increase the Euro-Zone’s contribution to global demand growth. This beggar-thy-neighbour policy is unsustainable and will intensify the currency wars that Dr. Draghi insists is not taking place.
Continued weakness in commodity prices and over-capacity in many industries mean disinflationary or deflationary pressures will persist, making the ECB inflation target unattainable.
Problems of refugees, terrorism, Russian revanchism and domestic political tensions (in Germany, Portugal, Spain, France and Greece) also increase uncertainty and reduce business and consumer confidence. European decision making processes remain at best slow and at worst moribund. The debt crisis exposed a North-South divide. Now, immigration pressures have revealed West-East differences. The option of greater integration has stalled. Europe-wide public finances, banking and government have become less not more likely. The spat over immigration threaten the Schengen Treaty, which would mark a major policy reversal. Domestic political pressures in Greece, Portugal, Spain, Italy, France and Germany are increasingly problematic.
Against this background, any improvement in Europe is more cyclical than structural. In the final analysis, the ECB’s action will, at best, maintain for a limited time an uneasy equilibrium. It will promote false hopes for a timely Euro-zone recovery. But as Sigmund Freud observed: “Illusions commend themselves to us because they save us pain and allow us to enjoy pleasure instead. We must therefore accept it without complaint when they sometimes collide with a bit of reality against which they are dashed to pieces”.