Daniel Lacalle

The ECB, Europe and The Real Growth Plan

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“The ECB and the creditor nations cannot and will not save governments that are unwilling or unable to save themselves”. RBS research

Slovenia has suddenly been forgotten by markets despite a banking system with average non-performing loan rate of 20%. This is what mass liquidity does to markets. If the country is in recession and the markets remain weak, it may need between 9 and 13 billion euros between 2013 and 2015 (25-38% of GDP, according to JP Morgan). If it follows a bail-in process like Cyprus, it will likely impact European banks by c15 billion. Austria, Italy, France and Germany would be the most affected.

This is why Draghi must keep his powder dry and cannot turn on the money printing press more than he has already. In the European ship there are holes everywhere, and we cannot demand the captain to repair the vessel and navigate to greater depths at the same time.

Mario Draghi commented recently that “the ECB’s policy “will remain accommodative as long as necessary” but can not “replace government inaction or undercapitalized banks.” And he is absolutely right. Monetary policy is not a substitute for inefficiencies.

In this regard, and considering the many press articles blaming the ECB for the troubles of the periphery, I would like to point out the most absurd myths about the European Central Bank. These are:1 – The European Central Bank does not print and does not support economies like the Fed does. The Fed’s balance sheet is 3.2 trillion (U.S. $), the ECB is 3.5 trillion. The ECB has increased its balance sheet by one and a half trillion dollars in four years, including 218 billion bond purchases (SMP).

The following BNP chart shows “ how the ECB prints more money than the Fed quietly“(from their report “Bigger than QE”).  It is an extremely revealing chart, and shows how the main beneficiaries of this policy were Italy and Spain, precisely the countries that complain the most about ECB “inaction”.

2 – The European Central Bank does not increases money supply . As we mentioned recently, the money supply (M3) has reached a maximum (9.7 trillion in January 2013 compared with an average of 0.33 trillion from 1980 to 2012). Nearly all of the increase in money supply has gone to one item: “Credit to General Government”. As RBS and BNP point out, the ECB has been as aggressive as the Fed , just silent. The problem is that all that liquidity has been absorbed between hypertrophied states and banks that have to buy sovereign debt, and almost nothing to SMEs and families. This is the governments’ “generosity” that “allows the private sector to save”. Unbelievable.

3 – Germany prevents Spain from recovering because they don’t allow the ECB to flood the market with money. We have seen that the money flows, but it stays in the pocket of governments and banks. We have seen that there is plenty of liquidity, but it is used to buy sovereign debt. We have seen that money is created, but the cost to borrow for businesses and families has sky-rocketed .The transmission system is simply flawed due to the greed of the heavily indebted states and financial institutions. Yet they say there is “no demand” for credit. I am amazed.

That transmission problem that prevents liquidity from reaching to the real economy is the fault of the member states who administer those funds, not the blame of Germany or the Bundesbank, which has two-thirds of its balance sheet exposed to the ECB, so they have little interest in seeing things get worse. But the ECB, Germany or the Bundesbank cannot just sit down and maintain unsustainable economies without reform. This reminds me of the words of a Finnish MEP: “The fact that I have lent a thousand euros to a friend and he has  spent it unwisely does not mean that he doesn’t owe me the money or that I need to lend him a thousand more.”

That is why Draghi’s words are so revealing.

There are perverse incentives in providing endless liquidity to countries that play the game of reaching the limit without reforms, wait to be systemic, get a bail-out and continue without changing bloated state structures, using the chequebook of others.

Solidarity is one thing. Donation is another. Especially when debt in Northern countries is not low. With debt/ GDP ratio of 90% and their own banking problems, doubling the bet on the periphery spending is suicidal.Germany, on the financial side, has a financial sector debt at about 45 times common equity and cannot take more peripheral risk easily. Especially when they have seen the disastrous results of the previous “stimulus” of 2007-2011.

On the social side, Germany cannot afford inflationary policies after decades of accepting disposable income losses, millions of mini-jobs and wage and pension cuts for the common good.

In simple terms, the construction of the new Europe cannot come from the same mistakes of 2007-2011, spending or borrowing, because the domino effect of systemic risk makes Europe weaker and more indebted.

European states are carrying a suicide policy against their own people masked as “social”. The pyramid of debt and accelerating spending is the same in most countries, and it is not sustainable. The ECB knows. And we should know that kicking the can forward without reforming inefficient and bloated states is not an option anymore.

I already commented this in my article “The Day After the Bailout, Internal Default” . Once 90% of the countries’ outstanding debt ends in domestic hands, the problem of government negligence will only be ours. Because 97% of the Spanish pension fund is invested in sovereign debt, 80% of the social security, many insurers, etc… Do we want to copy Japan and get to 240% debt to GDP? Then we should take internally the risk, just like the Japanese… Not pass the bill to the ECB or Germany.

No, the periphery problems are not the fault of Germany or the ECB. The countries are to blame themselves  for their lack of action in distributing this enormous liquidity. Perverse incentives appear again. The more liquidity, more debt in the wrong places -governments and banks-, delays in carrying out the necessary reforms, and nothing changes…

Of course, some Keynesian economists say central banks do not go bankrupt and should just print. Except that the central banks’ balance sheet is paid by citizens in taxes, inflation and ultimately impoverishment -devaluation and default- … and more cuts. We have seen it in the UK where monetary expansion has not prevented large cuts… or in Spain after massive countercyclical plans, which only deepened the hole and left tens of billions of debt.

It is precisely the government bubble and ineffective stimulus plans, funding the state in privileged terms and encouraging “spending” in low-productivity sectors, what explains much of the differential in the periphery compared to Northern countries.

The free bar of fake money does not solve problems of inefficiency, crony-ism and low productivity .

However, many economists maintain the myth that easy money and the European Central Bank printing is the solution to everything. After 1.5 trillion of expansion, putting 44 billion to buy Spanish government bonds and 230 billion to support its financial system they say it’s “not enough”. Really?.

On Thursday I attended the presentation “Spain, a land of Opportunities” by the  Business Council for Competitiveness. It has its voluntarism and optimistic predictions, but it is an excellent initiative. This document shows three realities:

1 – That the high-productivity sectors have grown and developed during the crisis in an exemplary manner with almost no additional credit.

2 – That despite a “strong” euro Spain exports more than ever.

3 – That the greatest mistake of the Spanish crisis was doubling the bet on the construction bubble with “counter cyclical” spending sprees, which have enlarged the hole and repressed healthy sectors with tax increases, while credit is monopolized by public administrations.

But even so, I hear things like “the fact that countercyclical policies have not worked in the past does not invalidate that they must be reapplied”. In a country that doubled its public debt to generate zero jobs, spent billions on useless infrastructure and built a structural deficit that is now very hard to contain. Repeat?.

I read a lot that the cost of financing SMEs would improve if the ECB flooded the system with liquidity. More liquidity? Curious, because the average spread to finance companies gained 300 points to 550 basis points precisely during the “open bar” of ECB liquidity. A transmission failure problem created by crowding out of public administrations is not solved with more liquidity. It is solved with free market and private funding. The monetary illusion leads us to think that adding water to the glass of milk makes us have more milk.

The myth that you have to spend when there is contraction and that saving will happen when the economy grows is simply untrue. Because governments do not save in prosperity. They spend more. And in any case, it is a futile discussion when we have crossed the threshold of debt saturation by a mile.

Repeating the mistakes of stimulating through government spending leads to perverse incentives that not only delay the recovery but makes our countries even more risky as an investment.

The best growth plan is lowering taxes and letting the high productivity sectors thrive, not drown them.Europe  can overcome the crisis deleveraging. Growth and credit will come from private sectors and private funding, attracting capital, allowing SMEs to grow, cutting political spending and rebuilding the middle class by increasing their disposable income. Reducing the weight of the State without destroying essential services  allows to lower taxes and boost consumer spending.

(This article was published in El Confidencial in Spanish)

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