James Saft, Reuters Columnist
The Federal Reserve and the European Central Bank are both keeping their options open as global economic conditions worsen and the euro zone looks, if anything, more fragile than in recent months.
The ECB did the absolute minimum at its meeting on Wednesday, leaving rates unchanged and extending some liquidity provisions until the end of the year. This despite clear signs of broad-based weakening in the euro zone economy and a widespread credit drought which looks very likely to worsen.
The Fed, for its part, is generally thought likely to temporise at its meeting this month, perhaps extending a reallocation of its bond portfolio intended to suppress short-term rates but, again, holding fire on any major new extraordinary monetary policy effort.
And yet investors mid-week pushed shares higher, partly wagering that Europe would get its institutions together but also in expectation that further distress would bring on further monetary policy medicine.
Well, it might, but it might not bring on the reaction many expect.
“It is truly hard to imagine that there is not enough monetary stimulus in the system with policy rates in most parts of the industrialised world at or close to zero and assets on central bank balance sheets tripling since the crisis began to an unheard-of 30-percent-plus share of GDP. But such indeed is the case and, frankly, is more a reason to be cautious,” David Rosenberg of Gluskin, Sheff wrote in a note to clients.
Quantitative easing has clearly had an impact on financial markets but the carry-through to economic activity is less clear. The first rounds in 2009 came as financial and lending markets were paralysed by fear. The effect was electric, in part because investors reasoned that it would allow for time to rebuild capital and spark inflation and growth which would make debt proportionally easier to bear.
Clearly the U.S. did a good job rebuilding bank capital, but keeping a banking system going is necessary but not sufficient for growth. Instead you could argue, and JP Morgan’s derivatives misadventure supports this, that having very low rates and ample liquidity but in a low-growth, debt-heavy economy has only set up incentives for speculation rather than long-term investment.
Growth has been slow and borrowers who should have failed kept alive, more in service to bank capital than to themselves or the broader economy.
Not 2009 all over again
And compared to 2009, the threat from the euro zone is both less tractable and larger. Europe’s banks, collectively, need a massive amount of capital, and that in an economy more reliant on bank lending. Moreover, there is no clear and workable chain of responsibility for European banks which leads to a solvent sovereign backstop. Spain’s banking system is small in proportion to Germany’s wealth, but one thing is different to another, and German voters don’t seem to want to use their money to support Spanish banks, at least without having Spanish fiscal policy brought under an integrated euro zone authority.
That conflict, not economic data, is the principal reason the ECB failed to ease. The central bank wants conditions to be tough enough to force action from political leaders. While both they and the Fed may be forced from the sidelines, monetary policy is not where the problem lies. It lies instead in Europe’s institutions and in Washington political manoeuvring.
Europe needs to get on with integration and Washington with fiscal reform. Both powers need to provide credible plans which foment long-term investment and bring state and private debts back into line with the size of their economies. State debts can be managed slowly, but private debt should be allowed to go bad and be purged as quickly as possible.
None of that is likely any time soon, meaning we probably will see coordinated central bank action in coming months. The interesting question is what the reaction will be. We’ve seen a pattern of diminishing returns to extraordinary monetary policy efforts since 2009, with economic growth remaining subdued and periods of euphoria and relief in financial markets becoming ever shorter.
The ECB’s long-term refinancing options (LTRO) are an example: easing conditions for euro zone state and bank borrowers for less time on each successive occasion.
Surely, of course, central bankers can create as much money as they wish, and just as surely this must inevitably have an effect on prices, or rather on nominal prices. But the idea that monetary policy can, by itself, rekindle animal spirits may have reached something like the end of the line.
If the easing comes at a time when the euro zone and Washington cannot give a credible account of what they are doing to resolve the underlying issues, quantitative easing may this time drive money under mattresses or into electronic last resorts rather than productive investments.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com )