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 “
— Deutsche Bank (@DeutscheBank) November 2, 2016
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:
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.
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