This week the European Central Bank has announced that it will maintain its asset buyback program, despite the fact that the European Union is neither in crisis nor in a recessionary shock. This is the first time in history that major central banks are making repurchases in excess of $200 billion a month without being in a period of crisis.
The European Central Bank launched a fresh defense of its monetary policy, saying that low interest rates and monthly asset purchases of €60bn have helped to stimulate growth and jobs in the eurozone and prevented the bloc from sliding into deflation.
“Our monetary policy was successful. The question is: is it time to exit or time to think about exit or not? This time hasn’t come yet,” he said. I am afraid he is wrong, ignoring financial risk accumulation and perverse incentives in over-indebted governments.
The growth figures of the European economy are good, and manufacturing indices are expanding. But they were already in expansion before QE was launched. The European manufacturing PMI is at six-year highs, the expected growth for 2017 will be 1.7% and 1.8% for 2018, unemployment will fall to 9.4% and 8.9% in 2017 and 2018 respectively, and growth of investment and credit is close to 2.5%. However, inflation by decree has been a failure, rising in energy and food prices and poor in core underlying inflation, a consequence of accumulated overcapacity and poor productivity.
You could say that these good growth figures are because of the ECB policy, but Europe was already expanding and recovering before they bought a single bond. Europe has been improving for five years. But that is not the debate. Even if we assume, for a moment, that the ECB policy has “worked” -despite 1.2 trillion euro of excess liquidity and high-risk bonds at the lowest rates in thirty-five years- the ECB must stop the monetary laughing gas urgently, for several reasons:
It runs out of tools before a cycle change. With zero interest rates, buying in some issues up to 100% of bond issues’ supply, and with new debt financing governments’ current expenditure and low productivity investments, whenever the economic cycle changes – and it does -, the central bank will have run out of its only historical tools.
After 600 rate cuts and buying tens of billions of dollars per month, it would create a boomerang effect that would generate more stagnation, Japanese-style. Anyone who thinks that the central bank can put negative types and increase money supply further and change everything is dreaming. What has not worked from 5 to 0% will not work from 0 to -5%. Financial repression does not lead agents to take more risk and invest, but to be more prudent, to hoard on liquid and safe assets, because monetary policy encourages over-indebtedness and perpetuates imbalances.
The ECB has already gone beyond the Fed. The ECB’s balance sheet already exceeds 36% of the Eurozone’s GDP and controls 10% of corporate bonds, a “nationalization” of the corporate debt market of almost 1% per month. In the case of the US, the Fed is c10 points below. Only the Bank of Japan surpasses the ECB, and we already know the level of debt and stagnation that the country has. The risk of following the path of Japan is not small.
It does more harm to the financial sector than benefits to the real economy. The bankruptcy of the zero-interest-rate policy is unprecedented and jeopardizes the consolidation process. Non-performing loans remain above 900 billion euros, operating margins and solvency ratios have plummeted to the lowest levels in a decade, and since the program was launched, Europe has seen three banking shocks, in Portugal, Italy, and even Germany. The impact on the financial sector is not compensated by the alleged economic improvement (a loss of almost 90 basis points in margins versus a slight increase of 15 in financial sector results, according to Mediobanca).
It does not help SMEs or families. While the ability to repay debt has not improved and cash or credit ratios remain poor, zombification of the refinanced sectors is soaring. High-yield is at the lowest interest rate in at least thirty-five years. Governments have saved more than 1 trillion euros in interest on the debt, of course, but, to my surprise, they have spent it all, and the ability of most European Union governments to adapt to an increase of only one 1% in the cost of debt is extremely low.
This leads to a rising tax burden despite the massive transfer of wealth from savers to governments, and – with it – it is extremely complex for SMEs and families to receive the slightest benefit of this extreme liquidity. Only 1% of SMEs have sought new credit, because their costs, excluding labor, have grown almost ten points more than their revenues, and of the meager 29% who requested a loan, only 69% received the required amount, according to the ECB. Despite extreme liquidity and low rates, demand for solvent credit remains very poor.
The huge risk of a bubble in bonds and financial assets is not offset by the supposed benefits of keeping the quantitative easing program. If we do not understand that accumulated risk is the root of the next crisis, we will repeat the mistakes of 2007.
Ignoring the risks that monetary policy generates in financial markets is very typical of central banks. It is thought that they can be mitigated, that they are acceptable and that they are not dangerous. And they are. They will be. Getting used to abnormally low rates and excessive liquidity to perpetuate imbalances is a huge risk. Not preparing for winter is suicidal.
Daniel Lacalle has a PhD in Economics and is author of “Escape from the Central Bank Trap”, “Life In The Financial Markets” and “The Energy World Is Flat” (Wiley)
Picture courtesy of Google