I am skipping the news links today to go right to the daily commentary. I want to continue my thoughts on what’s happening in Europe and why I think the ECB will become more activist. There are a number of policy options on the table for the ECB including continuing to stand pat. But given both what ECB board members are saying and what the Lisbon Treaty defines as the ECB’s mandate, I believe we are about to see a big shift in policy toward greater activism. I’ll explain why below.
Let’s a take a brief walk down memory lane to explain how we got here. We all know about the global linkages in the US subprime crisis. I spent a good deal of time in 2008 and 2009 creating a credit crisis timeline that shows effects going far and wide due to the global interconnections in the financial system. By late 2009, the global economy was healing from this episode. But European banks remained in a fragile state due to low capitalization levels and losses from the global financial crisis. Then, in November 2009, Dubai World happened. Just like HSBC’s February 2007 massive loan loss boost for its US subprime division Household International and BNP Paribas’s fund freeze in August 2007, this event seemed to come out of nowhere. And the result – as in the prior two crisis triggers – was panic.
There was no sovereign default in Dubai as investors from oil-rich Abu Dhabi rescued Dubai World. But, as I wrote at that time, “the next actor to watch is Greece, as they are keen to show their commitment to some degree of fiscal austerity as well. Unlike Dubai, unless they demonstrate a willingness to reduce the government budget deficit, they will be receiving no assistance.” And so the European sovereign debt crisis began.
Eventually though, we saw a bailout in Greece as well as in Ireland, Portugal, Spain, and Cyprus. So, indeed assistance came to Euroland as it did to Dubai because as I put it in November 2010, there were three options for the euro zone: monetisation, default, or break-up. And break-up would mean global depression. So that was out. But the terms of the bailouts were onerous: austerity, internal devaluation and depression. At the time, if you recall, there was a lot of chatter about who the lender of last resort in Euroland was and who could step in if Spain or Italy needed assistance. The problem was paragraph 123 of the Lisbon Treaty, which explicitly states that the ECB cannot monetise sovereign debt. What we saw, therefore, was escalating crisis as the ECB stood pat, limited by the eurozone’s institutional structure.
I outlined the relevant articles of the Lisbon Treaty for the sovereign debt crisis in November 2011 when Italy was on the brink. My analysis said that the EU had already invoked Article 122 to bail out Greece, Portugal and Ireland and was buying bonds in the secondary market despite Article 125. It seemed to me then as it does today, that Article 122 was very elastic, and could thus give the ECB a pretext to intervene in exigent circumstances. That’s why questioning Italy’s solvency leads inevitably to monetisation. Thus when I explained why investors will buy Italian bonds after ECB monetisation, I was clear that the crisis would continue until the ECB stepped in definitively. And only a credible ECB backstop would end the crisis – as it did when the ECB was finally explicit about monetisation following Draghi’s “whatever it takes” comments two summers ago.
After the “whatever it takes” episode, the convergence trade was on for exactly the reasons I outlined on why investors would buy Italian bonds after ECB monetisation. The brilliant thing from Draghi’s perspective was that his ploy didn’t require actual purchases at all. Just the credible threat of purchases has been enough, I think to everyone’s amazement. For me, this is emblematic of how yield starved investors are.
So that is the relevant history of Europe’s crisis. Let’s remember now that the reason we see deflation is because economic policy is geared toward it. Internal devaluation is a deflationary economic policy. So it should be no surprise that price levels in the periphery are receding. It’s a natural outgrowth of EU policy. The question goes to what to do about the negative economic impact of deflation i.e. the potential for debt deflation due to the rise of debt as a percentage of GDP as the economy contracted and debt rose and due to the increasing real cost of that debt. The compression of yields has dealt with the real cost of debt but the eurozone is still barely scraping by even after the compression of yields. Therefore, I think the worry about debt deflation is warranted. And having seen what the ECB was able to achieve with sovereign spreads, it makes sense that the ECB is again on the hot seat here.
Now, back in November 2011, former ECB chief economist Juergen Stark explained in an interview with the Frankfurter Allgemeine Zeitung why ECB opposition to monetisation is not about inflation. It is about resistance to moving the ECB into the politicised quasi-fiscal role that the Fed, the BoJ, and the Bank of England are already in. What Stark and others within the German camp want(ed) is for the hard choices to be made by fiscal agents who are elected by the citizenry rather than by the ECB, which is an unelected group of bankers. And in today’s situation, his commentary is telling, because now it is deflation that is the worry and the inflation canard is totally out the window. But, of course, with the real economy still weak and the fiscal austerity paradigm that Stark was using still in play, the ECB is now the only game in town. Last week, I wrote on an ECB tax on reserves, QE and other easing choices the ECB had. I say the ECB gets a green light on stimulus and that it can now decide what measures to take. And just as when the ECB’s paradigm shifted in November 2011, again it will rely on an interpretation of the Lisbon Treaty to make its next move.
These are the political and institutional considerations at work: The ECB has increased its balance sheet the least – Federal Reserve (363%), Bank of England (333%), the Bank of Japan (127%), and the ECB (49%) – in percent terms since financial crisis. And the eurozone is now the weakest of all these major economic areas. Given the differential in balance sheet expansion here and given the differential in growth, the pressure on the ECB to do something has mounted.
You may not know this but price stability is not the ECB’s sole mandate according to Article 123 of the Lisbon Treaty. I didn’t know this because, having read the Lisbon Treaty and quoted the relevant articles in November 2011, I had interpreted Article 123 as most did – that inflation was the sole mandate. But right on the ECB’s website it says something totally different. I will bold and underline the most important bits here:
Objective of monetary policy
To maintain price stability is the primary objective of the Eurosystem and of the single monetary policy for which it is responsible. This is laid down in the Treaty on the Functioning of the European Union, Article 127 (1).
“Without prejudice to the objective of price stability”, the Eurosystem shall also “support the general economic policies in the Union with a view to contributing to the achievement of the objectives of the Union”. These include inter alia “full employment” and “balanced economic growth”.
The Treaty establishes a clear hierarchy of objectives for the Eurosystem. It assigns overriding importance to price stability. The Treaty makes clear that ensuring price stability is the most important contribution that monetary policy can make to achieve a favourable economic environment and a high level of employment.
These Treaty provisions reflect the broad consensus that
- the benefits of price stability are substantial (see benefits of price stability). Maintaining stable prices on a sustained basis is a crucial pre-condition for increasing economic welfare and the growth potential of an economy .
- the natural role of monetary policy in the economy is to maintain price stability (see scope of monetary policy). Monetary policy can affect real activity only in the shorter term (see the transmission mechanism). But ultimately it can only influence the price level in the economy.
The Treaty provisions also imply that, in the actual implementation of monetary policy decisions aimed at maintaining price stability, the Eurosystem should also take into account the broader economic goals of the Union. In particular, given that monetary policy can affect real activity in the shorter term, the ECB typically should avoid generating excessive fluctuations in output and employment if this is in line with the pursuit of its primary objective.
So there you have it. Right there in Article 127 of the Treaty is the pretext that the ECB will use to justify its easing. And ease it assuredly will. The FT is reporting that the ECB is eyeing measures to boost lending to SMEs – basically an LTRO with strings attached, as I outlined last week. The Irish Independent also says that the ECB plans to cut rates at the June meeting. German newspaper Die Welt further explains that the ECB has already prepared a negative excess reserve deposit rate, though it does not say whether the measure will be implemented in June.
All of the above leads me to the conclusion that the ECB will become more activist and will take policy action on multiple fronts beginning in June. The reasoning will be that prices are not rising excessively, nor are prices at risk of rising through 2016 – and as such the ECB must act to avoid generating excessive fluctuations in output and employment. And that means taking a more activist policy stance in order to fully transmit ECB policy to the periphery and SMEs.
Mario Draghi has said previously that the ECB was concerned that their policy actions were not being “transmitted” effectively into the periphery and that this was grounds for future action. I believe that the fact that sovereign spreads have declined but lending to SMEs and lending rates to SMEs reflect poor SME liquidity favours the ECB’s using some mechanism to foster growth to small- and medium-sized business. The two possibilities floating around now are an LTRO-type initiative with the string attached that banks must supply credit to SMEs and a securitization mechanism to take credit off the books of banks that the ECB buys up so that these banks can go out and make more loans. Since banks are repaying the LTRO funds, causing the ECB balance sheet to shrink, I lean toward the second securitization option as the likely principal vehicle to help SMEs.
But the bottom line here is that, even in the absence of a specific rationale to fight disinflation and the prospect of deflation, the ECB has every legal right and ability to take an activist role in monetary affairs to support output and employment. I believe they will do. And June is when ECB activism will begin. And this is generally bullish for European corporate bonds.