In the US, UK and Japan quantitative easing is straight forward. The central banks just add a couple of extra zeros to their balance sheets and then go on a spending spree buying the country’s debt. If the ECB wanted to do quantitative easing it would have to buy the debt of its members. This might be exceptionally difficult
I wrote last May that the European economy was stagnating. It still is. With the exception of the equity and bond markets, the European economy has not got better since the beginning of the summer. Last month, the French gross domestic product (GDP) was flat. The Italian economy was in recession. Even the mighty German economy went negative. The Eurozone, as a whole, had stopped growing at all. So as usual, Mario Draghi and the European Central Bank (ECB) rode to the rescue. Last week, they announced a new stimulus package. The markets loved it at least for a day, but will it actually work?
Markets are all hoping and praying for a European version of quantitative easing (QE). But there is a problem. In the US, UK and Japan, quantitative easing is relatively straight forward. The central banks just add a couple of extra zeros to their balance sheets and then go on a spending spree buying the country’s debt. The ECB has no such luxury. If it wanted to do quantitative easing, it would have to buy the debt of its members. This might be exceptionally difficult.
It is not clear how the ECB would decide, how much of its member’s bonds to buy, but the effect would be uneven. If it bought bonds relative to output, it would buy mostly German bonds. Since the German 10-year bonds are already under 1%, it is doubtful that further buying will have much of an effect.
Buying other Eurozone sovereign bonds entails a large credit risk. Many of the countries are deeply in debt. Forecasts expect Greek debt to rise to 177.2% of GDP this year, Italy's to 135.2 %, Cyprus to 122.2 % and Spain's to 100.2%. Greece has already had a technical default. Ireland, Portugal, Greece and Cyprus have had bailouts. Italy’s bonds are rated Baa2, two levels above junk, as are Spain’s bonds.
It is not only the credit risk that a Eurozone QE would entail. There is also a large investment risk. Both, Italian and Spanish bonds are extremely high and yield less than much higher rated US bonds. Given their high debt and the weakness in the European economy, they have to fall sometime. If these bonds were owned by the ECB, it, or rather German taxpayers, might have to bear the loss.
So rather than attempt to tackle the political issues surrounding a full-blown QE, the ECB opted for purchasing asset backed securities (ABS). Asset backed securities are loans made by banks and other financial institutions, which then are sliced, diced and repackaged as bonds with various risk levels and resold to investors. The loans could be for anything from used cars to houses. You might remember them from the financial crisis. In the bad old days, US financial institutions repackaged loans secured by mortgages from risky borrowers known as subprime. At the time it was deemed “toxic sludge”. How times have changed.
Under the proposed plan, the ECB will buy up an unspecified amount of ABS. The idea is to take the ABS off the books of the banks in order to free up capital. In theory, the ECB would purchase hundreds of billions of euros of these instruments. But there is a problem. Since the financial crisis, the ABS market in Europe has been moribund. In the second quarter of 2014 to total amount for ABS issue was only €19 billion, which was 6% less than last year. The total amount issued last year was only €79 billion and the total outstanding instruments are only about €150 billion. Even if you add in the €200 billion mortgage backed securities, you really don’t get to the size contemplated by the ECB.
There are also many other problems. The infamous toxic sludge of the US markets was created to fill a burgeoning demand. The regulatory environment put in place since the crash, is supposed to prevent this, but it will also make the creation of new ABSs more difficult. If the regulations are relaxed, which is not under ECB control, all the money pouring into this sector almost guarantees a lot of really bad paper to be stuffed onto the ECB’s balance sheet.
This is especially true because the ECB has signalled its willingness to buy riskier ‘mezzanine’ tranches, provided Eurozone members are willing to guarantee the paper. The temptation to guarantee the debt of politicos’ cronies will be huge. You can just smell the corruption.
This is assuming that Europeans really want to borrow. Americans used to be more indebted than Europeans. Not anymore. Now American’s household debt in 105% of income after tax. Europeans are burdened with 110%.
It’s not just consumers. Many parts of the Eurozone are still hobbled by unsustainable debt built up by both the public and private sectors prior to the crash. With so much debt, they are actually paying it down, not adding to it. The additional cash is simply not wanted.
The cheap money already created by the ECB and other central banks has created real estate bubbles in various European countries: Belgium, Finland and France within the Eurozone. Norway, Sweden and Britain outside of it. Buying mortgage backed ABS will make this problem worse.
Since it will be extremely difficult for an ABS program to achieve the scale desired by the ECB, it is almost certain that QE will be back on the agenda. The risks I discussed earlier will make it extremely difficult. To get it passed Mario Draghi will need to get the Germans on board. It might be possible if France and Italy carried out structural reforms, which seems highly improbable.
The paradox is that more money will probably not have the desire effect on European economies without the structured reforms, but the extra money lessens the need for reforms. European countries wasted the years when the ECB bought them with the low interest rates. Their voters certainly do not see any need now.
Rock bottom interest rates have forced investors in Europe and elsewhere to pile into riskier assets in the search for yield. Many of these assets from real estate, to junk bonds, equities, sovereign bonds are arguably well into bubble territory. More money is not going to help. Further, it helps prop up weak creditors or zombie companies, preventing those from going under and reallocating capital to more successful enterprises that could actually help grow economies.
For years, investors and markets have been enthralled with central bankers. European wars and African plagues barely made it above the radar. Slow or no growth doesn’t matter. Just a few sentences from a central banker about more easy money were good for a rally. It is appealing to think that a few computer strokes can cure a continent’s ills, but I am afraid it doesn’t. This is one illusion that may be on its last legs and the hangover could last quite a while.
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William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first-hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and speaks four languages.)
