While not quite as full of fire and brimstone as his June report in which Deutsche Bank's chief economist, David Folkerts-Landau said that "The ECB must change", and in which he accused Mario Draghi of putting not only the ECB's future at risk, but the future of the entire Eurozone, with its destructive policies, overnight the German bank's top economist released yet another subversive if quite accurate analysis which could have come from your typical, fringe (blog which has accused the central banks of all of this for many years), in which Folkerts-Landau once again exposes that "dark sides of QE", listing "Backdoor socialisation, expropriated savers and asset bubbles."
And, in an amusing twist, none other than Deutsche Bank's twitter account subtweeted the ECB earlier this morning pointing out that "ECB intervention: negative repercussions are becoming overwhelming "
While the 6-page paper does not contain anything particularly groundbreaking, the fact that DB continues to push the openly confrontational narrative, demanding the ECB unwind its extraordinary measures, suggests that the German bank continues to suffer, and most importantly, this outright bashing of Draghi's policies received the explicit green light of John Cryan.
The summary of the note, as crystalized by Bloomberg, is the following: "While European central bankers commend themselves for the scale and originality of monetary policy since 2012, this self-praise appears increasingly unwarranted,” because, as he concludes, “ECB is stuck ... between an unfavorable equilibrium of low growth, high unemployment and zero reform momentum on the one hand and growing risks to core country balance sheets on the other.”
Here are the main points of the report. Stop us if you have heard these countless times in the past:
The dark sides of QE
Backdoor socialisation, expropriated savers and asset bubbles
While European central bankers commend themselves for the scale and originality of monetary policy since 2012, this self-praise appears increasingly unwarranted. The reality is that since Mr Draghi’s infamous “whatever it takes” speech in 2012, the eurozone has delivered barely any growth, the worst labour market performance among industrial countries, unsustainable debt levels, and inflation far below the central bank’s own target.
While the positive case for European Central Bank intervention is weak at best, it seems that the negative repercussions are becoming overwhelming. This paper outlines the five darker sides to current monetary policy.
The first is a paradox of ECB intervention: that monetary policy stifled the very reform momentum it sought to create. Up until July 2012, high interest rates and refinancing threats forced governments to be serious about reforms. Indeed, pre-2012, more than half the growth initiatives recommended by the OECD were being implemented across the eurozone. But last year just twenty per cent were. ECB intervention has curtailed the prospect of significant reforms in labour markets, legal systems, welfare systems, and tax systems across the continent.
Second, bond prices have lost their market-derived signalling function. Since investors began to anticipate sovereign purchases by the central bank in late 2014, intra-eurozone government bond spreads have been locked together. In turn, misrepresentative sovereign yields distort the whole fixed income universe that is priced off government debt.
Perhaps the darkest side of ECB monetary policy is the increasing concentration of risk on the eurosystem balance sheet – expected to be EUR 2tn by March 2018. In the event of a debt restructuring of a eurozone member, the liabilities of the national central bank are likely to be borne by the taxpayers of the other eurozone member states, even if losses are spread over a long period. Fundamentally, however, the debt will have been socialised.
Fourth, ECB intervention has not been a net positive for eurozone savers. While high and stable revaluation gains have buttressed total returns over recent years, this is clearly a one-time gain. Today, rising energy prices, the shortage of high coupons and ultimately mean-reversion are likely to take their toll.
Finally, the misallocation of capital caused by ECB policy is preventing creative destruction and causing asset bubbles. Increased lending has gone mostly to low quality existing borrowers while obviating troubled banks from the need to write down loans. Without creative destruction in ailing industries, investors in high-saving countries have simply bid-up the price of healthy assets.
One of the most salient points, and one we have been pounding the table on ever since the start of QE, is what the economist callsed the "paradox of EVB intervention", which can be simply summarized as monetary policy stifling the very reform momentum it sought to create. To be sure, this website has said ever since the start of the decade, that through their monetary intervention, central banks obviate the need for much harder, structural reform (which can cost politicians their careers) and fiscal policy. Folkerst-Landau is one of the most prominent strategists to agree with this:
Up until July 2012, high interest rates and refinancing threats forced governments to be serious about reforms. Indeed, pre-2012, more than half the growth initiatives recommended by the OECD were being implemented across the eurozone. But last year just twenty per cent were. ECB intervention has curtailed the prospect of significant reforms in labour markets, legal systems, welfare systems, and tax systems across the continent.
To undescroe his point he shows data which clearly demonstrates that t“deficit countries” – France, Estonia, Greece, Ireland, Italy, Portugal, Slovakia and Spain – made a much greater effort in 2011 and 2012 than they did last year. Indeed, the OECD itself says that in the early part of the European debt crisis “reform responsiveness” was greater in countries that were facing more difficult circumstances, though that correlation has broken down somewhat lately. The OECD also warns against over-interpreting year-over-year changes too much, as many types of improvements to economic frameworks take years to complete.
As Bloomberg adds, Folkerts-Landau draws a conclusion that the OECD does not, namely that the reason for this slowdown is the more favorable conditions that the deficit countries are enjoying on bond markets, in particular after the ECB announced its OMT bond-buying plan in 2012. That compressed bond yields as well as the urge to reform, he argues. “Any incentive to reform disappeared with the guarantee to bail out countries in need via OMT."
Some other valid criticisms from the DB economist:
- Bond prices have lost their signalling function: Another casualty of ECB policy is financial analysis. Since the last few months of 2014, when markets began to anticipate sovereign purchases by the central bank – subsequently announced in January 2015 – intra-eurozone government bond spreads have been more or less locked together. For example, Italian and Spanish bond spreads versus bunds have hovered in a 120 basis points range, notwithstanding the political risks in both countries. By contrast, Portuguese bond spreads have increased almost 120 to 310 basis points during the past 12 months, due to heightened concerns that the only remaining agency rating Portuguese debt as investment grade might change its assessment – which ultimately has not happened – thereby making them no longer eligible for quantitative easing.
- Mounting strain on the eurosystem balance sheet: Potentially the biggest negative repercussion of ECB monetary policy is the fate of the substantial claims by the central bank on member countries held through the eurosystem balance sheet. Based on the potential losses a core country is theoretically on the hook for given the costs associated with the two main rescue funds (EFS and ESM), quantitative easing and Target2, it is inconceivable that any member country would be allowed to fail, save a small one with limited contagion effects.... Target2 imbalances are already elevated and will continue to rise. These imbalances, which are a proxy for the accumulated current account deficits or surpluses of eurozone member countries to each other, first became an issue during the periphery funding crisis in the first half of 2012. Then, capital flight from periphery countries to core economies increased imbalances substantially. These subsequently narrowed in 2013 and 2014 after President Draghi’s “whatever it takes” speech. However, they have subsequently moved back to levels experienced during the heights of the bank funding crisis in 2012. As researchers from the Dutch Central Bank suggest in a recent article, this is partly due to quantitative easing. Investors who sell assets under quantitative easing to their national central bank in vulnerable countries have tended to put the proceeds into bank deposits in countries with the highest perceived creditworthiness. The recent surge in Target2 imbalances is slightly different compared with 2012 in that it is supply-driven (quantitative easing) rather than demand-driven (capital flight). But the underlying logic is the same.
- Difficult times for savers. The effect on savers’ ability to plan and execute long-term planning is another negative externality of the prolonged low and negative interest rate environment. For German households thus far, the ECB and Bundesbank are correct in pointing out that the impact on savers has so far been limited, but it is not clear for how long this can continue. Consider that nominal total returns for German households have averaged 3.4 per cent over the past four years, similar to the average throughout the 2000s and similar to the rest of the eurozone. In fact, real returns even trended upwards due to declining inflation since 2012. Even nominal returns on interest-bearing investments did not slip below two per cent until 2015 because a large proportion of longer-dated and mostly higher-coupon investments dampened the effect of evaporating market returns. In this sense, the evidence suggests that savers have not yet suffered the full brunt of ECB monetary policy. However, many of these effects are unrepeatable and likely to be exhausted.
- No creative destruction, many asset bubbles. While ever-lower rates were meant to encourage real economic activity, investment opportunities remain scarce due to the lack of structural reforms and creative destruction in inefficient industries. OMT and the collapse in bond spreads benefited the worst-quality borrowers disproportionately. In their paper “Whatever it takes: The Real Effects of Unconventional Monetary Policy”2, Acharya et al. show that peripheral banks with large holdings of national sovereign debt enjoyed a “recapitalisation through the backdoor” from revaluation gains. These banks increased lending, but mostly to low quality existing borrowers. Such firms benefitted from rates often below what high-quality public borrowers had to pay, and used cheap funding to repay debts, instead of financing employment or investment. The authors show OMT supported “zombie companies” via evergreening, which prevented banks from the need to write down the existing loans. Without the creative destruction of ailing industries, investors have simply bid-up the price of healthy assets. These now function as the exhaust valve, especially in countries with substantial net savings. The flipside of tumbling yields across Europe is therefore inflated asset prices and a general hunt for yield.
The DB report wraps up the complaints into a familiar lament: the ECB has unleashed moral hazard on such an unprecedented scale that it will be simply impossible to unwind the trillions in stimulus.
The euro’s design – a combination of unified monetary policy and national fiscal policy where rules can be ignored without sanction – is flawed. But with Mr Draghi’s promise of “whatever it takes” the implied moral hazard was pushed into a much larger dimension.
There are two broad options now. The eurozone could move towards fiscal union and the sharing of liabilities. Alternately, policymakers could install a system more geared towards individual fiscal responsibility, via re-introducing market-based pricing of sovereign risks. The former is not being proposed by any national politician in the eurozone, because it is unpopular. The second could be the ideal solution, though it is difficult to imagine politicians seeking re-election in the periphery to back a move to raise risk premia on their own assets. Moreover it would likely also be rejected by the ECB, since it would – at least in the ECB’s own logic – undermine the effects of its monetary policy.
The conclusion is as scathing as anything we, or any other rational thinker could have put together:
And so the ECB is stuck, as it has been since 2012, between an unfavourable equilibrium of low growth, high unemployment and zero reform momentum on the one hand, and growing risks to core country balance sheets on the other. It remains to be seen how it will escape from this dilemma of its own making.
How will the ECB respond to this latest criticism? The same way Mario Draghi always has reacted to unkind words, by sarcastically casting it aside, and telling his fawning fans that all that is needed is a little more time, a little more QE and slightly lower rates and everything will be fixed. And if that fails, then "whatever it takes"... again.