European Affairs

The debate is immediately complicated by last week’s deadly attack in Paris, which may result in a short-term slowdown in consumer spending but, if past examples of economies buffeted by terrorist attacks hold true, will likely regain course. Then there is “chapter three” of the global debt crisis, which began in 2008. An acceleration of the slowdown in emerging markets, led by China, is underway as a consequence of an unsustainable borrowing binge.

Source: Nicholas Wells, “The economic consequences of Paris.” CNBC, November 26, 2015.

The “free money,” or borrowing at near-zero interest rates, has forced down the euro’s value, resulting in more competitive pricing of goods and services, and jump-started construction and other key sectors that heavily depend on credit access. History shows, however, that credit-driven asset bubbles cause volatile distortions in real estate values and skew investment away from sustainable, long-term, job-creating enterprises, the critics say. They point to the problems in China as the most recent evidence to support their argument, specifically the overbuilt housing market, which includes a recreation of an English country village, empty of any residents, and the down-throttling economy.

Source: Stefano Micossi, “The Monetary Policy of the European Central Bank (2002-2015).” Bruges European Economic Policy Briefings 35/2015.

Lord Adair Turner’s new book, Between Debt and the Devil: Money, Credit, and Fixing Global Finance, is the latest and perhaps one of the most persuasive arguments against QE to cause ECB President Mario Draghi to pause before pushing his foot even harder on the gas pedal. The former head of the U.K. securities regulator and the author of one of the most enlightening inquiries into the causes of the 2008-2009 global financial crisis draws from his experiences and analysis of many studies to make his case.

“If credit finances consumption rather than useful investment, it is more likely that the debts created will subsequently prove unsustainable,” he writes. The same is true for public-sector debt: “fiscal deficits that finance consumption rather than growth-enhancing investment are more likely to produce unsustainable public debt burdens.”

More and more credit induces speculation which, in turn, drives up asset prices that produce gains in the early part of the inflationary cycle, profits that are plowed back into other assets, thereby compounding the inflationary spiral of asset values. The wealthy are the beneficiaries, widening the rich-poor gap. As soon as lending tightens, or the trees stop growing skyward, the boom unravels and real estate values implode, as Americans saw between 2007 and 2009.

This instability through invariably excess credit creation is “hard-wired” into the modern financial system, Adair contends, his most daring assertion that some reviewers of his book see as radical.
 “Modern financial systems left to themselves inevitably create debt in excessive quantities and in particular debt that does not fund new capital investment but rather the purchase of already existing assets, above all real estate. It is that debt creation which drives booms and financial busts: and it is the debt overhang left over by the boom that explains why recovery from the 2007-2008 financial crisis has been so anemic.” (pp. 3-4)

Source: Adair Turner, Between Debt and the Devil: Money, Credit, and Fixing Global Finance. Princeton, N.J.: Princeton University Press, 2015.

And, this approach serves developed economies, which he describes as largely distributive, moving assets from one owner to another, rather than creating new wealth. For economies to grow, they need to increase demand, which means lowering unemployment, raising wages, and increasing savings. Adair seems to have exhausted his energy in proposing solutions to do so beyond having central banks buy public debt. 

Those rallying behind Draghi’s program to pump $1.8 trillion (€1.14 trillion) into the Eurozone through cheap, long-term loans to banks say the stabilization and emerging, if hesitant, growth are immediate proof of the ECB’s success. The ECB’s own study shows that long-term cheap loans (TLTROs) given to banks had translated into more than $107 billion (€100 billion) of credit to companies and long-term sovereign debt rates have fallen by about 30-50 basis point for 10-year bonds.[1]

There are few tools to promote expansion, and the one Turner favors, government spending, even if financed by borrowing nonstop form the central bank, has tremendous costs to the economy, too, and may plant the seeds of a recession and deflation as a consequence of the resulting debt overhang. Expansionary fiscal policy is no help, monetarists contend, having “crowding out” consequences in diverting capital to government programs rather than into productive enterprises.

spellman201511chart24Source: Alessandro Speciale, “Draghi Passes ECB Halfway Mark Still Missing Inflation Goal.” Bloomberg, November 2, 2015.

While both camps disagree sharply on the use of debt to drive economic growth, they agree on the need to rethink the post global crisis orthodoxy in how central banks work to promote prosperity and what policymakers can do to restructure moribund economies so jobs are created for the long term. Draghi’s initiatives so far are experimental, having never been attempted before on the scale and duration he has initiated. Some think the ECB should rethink the goals (abandon the inflation target) and go beyond its current approach of pumping money into the economy through the banking system to include regulatory reforms (reduce non-performing loans of European banks) and changing the ECB portfolio of debt holdings (move into corporate bonds). Here are three ideas under discussion:

Reconsider the two-percent inflation target as a key objective

Since the program began in 2013, inflation has stagnated below one percent. “With the average annual change in euro region consumer prices at minus 0.1 percent so far this year, Draghi has been forced to bow to reality,” Mark Gilbert, a Bloomberg columnist wrote. “Pretending that 2 percent can be reached when his preferred measure of market expectations – the five-year rate on five-year forward inflation swaps – has been below that target all year isn't helpful.” [2]

Markets have already been pricing in the likelihood that a 10-basis-point cut in the ECB deposit rate will occur within the first two quarters of 2016, according to Jens Peter Soerensen, chief analyst at Danske Bank in Copenhagen.[3] That has failed to spark inflation, though.

Address banks’ non-performing loans

“Weak bank balance sheets have long been known to act as a drag on economic activity, especially in economies that rely mainly on bank financing,” write Shekhar Aiyar, Anna Ilyina, and Andreas Jobst, economists at the International Monetary Fund.[4] Banks in Europe have higher percentages of non-performing loans to assets than those in the United States and Japan, their research shows, and their write-off rates are far lower, too. An estimated $889 billion (€826 billion) of NPLs are on the balance sheets of European banks that are supervised by the ECB’s Single Supervisory Mechanism.[5]

Tax codes, accounting rules, and thin markets for distressed debt block European banks from sweeping the liabilities off their financial statements. For growth to take hold in Europe, this burden needs to be addressed in three ways: 1) tougher bank supervision by the EC and national regulations that may include requirements to incentivize banks to resolve NLPs by mandating that banks set aside higher levels of capital for NPLs; 2) overhaul bankruptcy laws by harmonizing the legal frameworks of EU member-countries; and, 3) expand and strengthen credit markets for distressed debt. Other IMF economists point to the emergency measures taken by Japan in 2001 and 2002 as an example to guide development of distress-debt markets.[6]

Source: Shekhar Aiyar, Anna Ilyina, and Andreas Jobst. “How to tackle Europe’s non-performing loan problem.” Vox, November 5, 2015. .

Expand pool of debt ECB buys 

Already, the ECB buys, sovereigns, supranationals, agencies, state-backed corporates, covered bonds, and asset-backed securities. The ECB has been encouraged to expand the pool of debt it has been buying to include corporates and bonds issued by cities and regions.[7] Reuters has reported that municipal and regional bonds are under consideration, a market of $500 billion, according to data from Thomson Reuters IFR. Some are advocating the inclusion of non-financial corporates. “The ECB could decide to go further into the pool of euro-denominated non-financial corporate bonds $956.8 billion (€893 billion) rated BBB and above, including € bonds from non-Eurozone issuers $736.1 billion (€687 billion) excluding non-Eurozone issuers,” says Alberto Gallo of the investment bank RBS. Draghi has hinted at such an expansion at a press conference after the governing council meeting in Malta in October. The asset-purchase program, he said, provided “sufficient flexibility in terms of adjusting its size, composition and duration.”

Source: Tyler Durden, “Is Mario Draghi About To Go Full-Kuroda? RBS Says ECB Could Buy Stocks.” ZeroHedge, October 23, 2015.


spellman201511chart27Source: Bloomberg. .

The ECB initiatives are untested, and a verdict now is limited given that the long-term impact – the trickle-down structural changes to generate jobs and expand business activity – takes months to begin to materialize. One analyst dubbed the U.S. economy a supertanker, very slow to maneuver towards a new direction, its small movements having a large and reverberating impact. The same can be said of Europe. Short-term, the immediate consequences of the ECB’s actions are evident in declines in both the euro’s value and interest rates for government and corporate bonds. For the long term, a shift away from deepening the ECB’s debt holdings towards addressing constraints on economic growth – notably the non-performing loans of Europe’s banks – and changing the goals away from the inflation target towards other metrics of growth are prudent. 

[1]Carlo Altavilla, Giacomo Carboni, and Roberto Motto, Asset purchase programmes and financial markets: lessons from the euro area.” ECB Working Paper No. 1864, November 5, 2015. .
[2]Mark Gilbert, “The Quantitative Easing Experiment Is Failing.” Bloomberg, October 29, 2015. .
[3]Anooja Debnath, “European Bonds Decline After ECB Survey Signals QE Effectiveness.” Bloomberg, October 20, 2015. .
[4]Shekhar Aiyar, Anna Ilyina, and Andreas Jobst. “How to tackle Europe’s non-performing loan problem.” Vox, November 5, 2015. .
[5]Linklaters, “NPL European banks face significant credit risks as the SSM focuses its attention on non-performing loans.” November 2, 2015.
[6]Nadège Jassaud and Kenneth Kang, “A Strategy for Developing a Market for Nonperforming Loans in Italy.”
IMF Working Paper WP/15/24. February 2015. .
[7]John O’Donnell, “Exclusive: ECB mulls buying debt of cities and regions.” Reuters, November 11, 2015.