For the past couple of years the European Central Bank has been the only sane
inmate in the asylum. Unfortunately, in a crazy world being sane just gets
you into trouble. Sound monetary policy leads to a strong currency, which in
a currency war is tantamount to unilateral disarmament. Unable to export sufficiently
to a world of weak currencies, the eurozone is tipping into deflationary depression
(with several members already there and unable to get out). So...
Mario Draghi's asset-purchase plan to ward off deflation may be lacking one
key element: enough assets to buy.
Since the European Central Bank President buoyed investors last week by
saying policy makers backed quantitative easing as a way to boost prices
if needed, officials including Governing Council member Ewald Nowotny have
signaled any purchases may center on asset-backed securities. While that
makes sense in an economy funded mostly by bank loans, it's also a market
Draghi once described as "dead."
The ECB's focus on ABS for monetary easing risks guiding it toward a policy
that might be slow to evolve and far smaller than the 1 trillion euros ($1.4
trillion) in bond purchases it has already simulated. Draghi has said international
regulators must change the rules on ABSs, yet those officials are steering
against the easy creation of complex products because of the role they played
in the global financial crisis.
"A preference for ABSs has been expressed time and again - - and in fact
it is the first asset class that would make sense for the ECB to buy," said
Marco Valli, chief euro-area economist at UniCredit Global Research in Milan. "The
market's revival is conditional on the regulator changing capital requirements.
Until this changes, jump-starting the ABS market is difficult and demand
for these securities will remain weak."
Total issuance of securitized assets in Europe was 250.9 billion euros in
2012, compared with the equivalent of 1.55 trillion euros in the U.S., according
to data compiled by the Association for Financial Markets in Europe. Issuance
in the first half of 2013 was 83.5 billion euros in Europe and 880 billion
euros in the U.S. Moreover, some European securitizations are used as collateral
against loans from the central bank, making them unavailable for an ECB purchase
program.
The total of European issuance would be dwarfed by the size of at least
one QE simulation run by the ECB. Officials ran models testing the impact
of purchases of 1 trillion euros of bonds, a person with knowledge of the
matter told Bloomberg News on April 4.
Large Pool
Greece's central bank governor, George Provopoulos, said in an interview
yesterday that the ECB Governing Council is now "reflecting" on the design
of a quantitative-easing program.
The ECB is "unanimously committed to using all instruments within its mandate,
conventional and unconventional, to deal effectively with the risks of a
too-prolonged period of low inflation," he said in Athens.
Draghi said on April 3 that the ECB could access a bigger pool of securitized
bank loans if only there was a more-liquid market in which to do so. The
total stock of outstanding loans in the euro area was 17 trillion euros at
the end of 2013, according to ECB data.
"If we are able to have these loans being correctly priced and rated, and
traded, like it would happen, like it used to happen in the ABS market before
the crisis, then we naturally have a very large pool of assets," he said
at his monthly press conference.
Joint Paper
The ABS market can only function better with the help of rule-setters including
the Basel Committee on Banking Supervision and the European Union, officials
say. The central bank has said that current capital requirements are too
strict for banks holding ABS.
"It is clear to everyone that the ECB feels that EU ABSs are being treated
inappropriately by present regulations and proposals," Executive Board member
Yves Mersch said on April 7. The ECB and the Bank of England will present
a joint paper on revamping ABS regulation this week at the Spring meetings
of the International Monetary Fund in Washington.
Some thoughts
To create an asset-backed bond, a consumer or business has to first take
out the kind of loan that can be packaged into a bond. So the underlying point
of the ECB buying such bonds is to convince Europeans to borrow more money
on cars and houses.
Not so long ago the idea of a central bank buying asset-backed bonds would
have been seen as both dangerously experimental and as crossing a line into
industrial policy, where the government intervenes in the marketplace to pick
winners and losers. In the US case, the Fed buying mortgage-backed bonds is
an explicit subsidy to housing and the banks that depend on it. The result:
more Americans are buying homes they probably can't afford and the big banks
-- because their too-big-to-fail status makes them in effect government-guaranteed
entities able to borrow at artificially-low rates -- are taking an even-more-dominant
share of the mortgage business. In no rational world could this be seen as
a proper or wise use of taxpayer resources.
In Europe the effect will be similar, with central bank asset-backed bond
purchases subsidizing the big banks that originate and package the loans. That
the European ABS market is currently small means that the ECB will be explicitly
directing its citizens to borrow more money from banks, which will then package
those loans into bonds and, in effect, sell those bonds to taxpayers (the people
who were directed to borrow the money in the first place). Again, in no rational
world is this logical or sound policy.
And yet this is how the currency war is being fought. The euro is too high
due to Europe's excessive debt and the ECB's previous reluctance to inflate
those debts away. This is pushing the Continent's worst-run countries (of which
there are many) into a deflationary spiral from which they can't escape with
the euro worth $1.35. So from the point of view of politicians who want to
be reelected, the only solution is a cheaper currency achieved via a much higher
money supply, which in turn is achieved by encouraging the banking system to
write more loans.
Nothing about this is new, other than the entities making the policy mistakes.
If the ECB succeeds in pushing the euro down to, say, $0.90, then France, Italy
and Spain will stabilize while failed US states like California and Illinois
implode. And the focus will shift back to the dollar, leading to a new round
of Federal Reserve QE, and so on. With each iteration the total amount of global
debt will rise, making the required monetization and market manipulation that
much more extreme, until, finally, the major economies realize that the only
kind of devaluation that sticks will be against gold.
I'll go out on a limb and predict that well before the end of this decade
a new monetary regime will be announced in which all the major currencies are
linked to gold at an exchange rate equivalent to $10,000/oz. Everyone with
fiat currency savings will lose 80% of their purchasing power, while everyone
with hard asset savings will see a commensurate increase in real wealth.
Assuming, of course, that governments allow this wealth transfer to take place.
By the time monetary panic makes a new gold standard conceivable, lots of other
things, like wealth taxes and asset confiscations, will also be on the table.
So buying hard assets is just the first, easiest step. Keeping them will take
a lot more thought and planning.
