In two days Mario Draghi may, although without Germany's blessing most likely will not, announce vague terms of how the ECB plans on monetizing hundreds of billions in short-term (sub-3 Year) bonds by Spain and Italy, which according to the ECB is not really monetization, and the only thing that is needed is for the two countries to admit they are insolvent, something which paradoxically will never happen as long as the ECB does everything in its power to spook markets away from fair clearing levels, and to keep the cashflow implied price at record divergence from the centrally-planned "valuation" determination. But let's assume Draghi does go ahead and one up Bernanke, announcing the next easing round a week ahead of the September FOMC meeting, as both central banks take the lunge into the latest lap of currency devaluation. What happens then? Well, as JPM's Michael Cembalest puts it quite succinctly, Draghi will unleash nothing short of the transformation of the ECB from the European Central Bank to the European Creosote Bank (see below for the reason). Numerically, this will mean that once the ECB is done monetizing another €1 trillion or so in bonds in the next year, the ECB will then hold just shy of a unimaginable 50% of the entire Eurozone GDP, taking the New Normal monetary world well beyond the rabbit hole and deep inside the twilight zone.
One thing is certain: if the ECB reaches the nosebleed levels predicted above, all the other central banks will not stand idly by, and will certainly join in to do more of the same. In fact, it is almost assured that by the end of 2013 half of the developed world's GDP will be held by its central banks. It is also certain that since central-planning always fails, the outcome of this aggregation of assets, will mak the Mr. Creosote scene below a pleasant appetizer to what will happen once the world's monetary machinery burps and forces the pipeline to hit reverse.
How Cembalest sees the festivities unfold:
ECB President Draghi said all steps will be taken to preserve the Eurozone, and that elevated Periphery credit spreads are interfering with EU monetary policy. As a result, he will presumably step in to correct them by either buying bonds or lending to entities that will do it for him.
In doing so, the ECB’s balance sheet could easily grow by another trillion Euros (see below), at which point it’s fair to describe it as the European Creosote Bank. I can’t go into much detail as to what I mean by that; it has to do with a fictional character who sat down for dinner and ate several plates of mussels, pate de foie gras, beluga caviar, eggs benedict, leek tart, frogs' legs, and quail's eggs; a plate of jugged hare with truffles, bacon, Grand Marnier, anchovies and cream; all washed down with six bottles of Château Latour, a jeroboam of champagne and six crates of brown ale. The results in this case were not pretty.
How will it work out in Europe? The immediate benefits of central bank debt purchases feel great: defaults by banks and governments are postponed, banks benefit from increased net income due to cheap funding from the central bank, and there’s a perception of normalcy as the ECB forces short-term bond yields back down. Markets get a respite from bad news, since investors don’t have to wake up every morning to see what happened in Europe that day...
There aren’t many precedents for what the ECB indicates they may do. Of course, one thing we are watching is inflation in Germany. While wage gains are starting to pick up and home prices are rising modestly for the first time in a long while, economy-wide German price increases are still well below 2%.
Another risk relates to losses at the ECB. Central banks can recognize losses over long periods of time, and do not have to disclose how or when. They can even earn “seigniorage”, which refers to the difference between the yield on bonds they buy or lend against, and their cost of money (zero). Eventually, however, the ECB might have to engineer a massive “Paris Club” debt renegotiation, which is how governments forgive and restructure debt owed by developing countries. A Paris Club outcome seems more likely than the ECB having an actual exit strategy for its purchases and loans. After all, let’s remember why the ECB is printing like crazy: southern Europe is seeing the largest outflow of capital that the modern world may have ever seen (see below). Pictured from above, it rivals the great annual migration of the wildebeest across the Serengeti, and the chaotic migration of millions of Hindus, Sikhs and Muslims when British India was divided into India and Pakistan in 1947. Without the ECB, there would probably already have been more sovereign and/or bank defaults in Europe.
To summarize: From the Creosote Bank to the second coming of the Paris Club. And all made up as we go along. Surely, there will be no tears at all involved as this entire tragicomedy mercifully comes to a close. Eventually.
In the meantime, here is another tragicomedy.