James Bullard, president of the Federal Reserve Bank of St. Louis, suggested on May 21 that Europe consider quantitative easing similar to that undertaken by the Fed, which he believes to be a "reliable tool" (link to presentation here.)
It is rather unusual for a central banker to offer specific advice in public to central bankers in other countries. In fact, almost precisely this time last year, Mr. Bullard declined to recommend specific policies to Europe. Now he's offering recommendations to Mario Draghi, whom he spoke to ahead of the meeting. What changed his mind? Why is a Fed branch president giving advice to the ECB president? Why couldn't he have just said it in private?
I believe there is a strong possibility that this move reflects a consensus on behalf of the economic policymaking community in the U.S. and Bullard is just the messenger. Of course, this is a fair bit of guesswork, as Mr. Bullard "said he was speaking for himself and not the Fed or any other members of its policy committee" but if this is such a rare move, it probably wouldn't have been done without previous communication with his superiors, unofficially at least.
Why care about Europe?
Well, growth in Europe right would really help the U.S. now. That might be why Obama sent Treasury Secretary Jack Lew to "seek less austerity in the eurozone", though it may have fallen on deaf ears: "Nobody in Europe sees this contradiction between fiscal policy consolidation and growth," said Mr. Schäuble [German Finance Minister]. "We have a growth-friendly process of consolidation."
There's no appetite for fiscal stimulus and monetary stimulus is already causing problems that may cost more than the benefits. With growth prospects in China uncertain and Japan getting a green light on devaluation, Europe might be a better place to find growth, since austerity is a man-made phenomenon that's artificially depressing things over there.
A few interesting factoids from "The Transatlantic Economy 2013" by SAIS Center for Transatlantic Relations, Johns Hopkins University:
- The transatlantic economy generates $5.3 trillion in total commercial sales a year and employs up to 15 million workers in "onshored" jobs on both sides of the Atlantic.
- U.S. Foreign Affiliate Sales to Europe totaled $2.6 trillion in 2011.
- On a historic cost basis, the U.S. investment position in Europe was 14 times larger than the BRICs and nearly 4 times larger than in all of Asia at the end of 2011.
- Most surprising: over the past two years U.S. companies have actually disinvested in China. They on balance withdrew investments from China of $1.7 billion in 2011 and $4.8 billion in 2012, while investing $224.3 billion in Europe in 2011 and $203.3 billion in 2012.
- Despite Europe's uneven economy, 45 of 50 U.S. states still exported more to Europe than to China in 2012, and by a wide margin in many cases.
- January-September 2012 Florida exports to Europe were more than 11 times its exports to China; New Jersey exports to Europe were 9 times greater than to China. New York, Connecticut and Virginia each exported 7 times as much to Europe as to China.
Why QE in Europe?
Let's get back to Bullard's recommendation for the ECB to engage in QE. In his presentation, he notes that :"Traditional effects of "easier monetary policy" include (1) higher inflation expectations (2) currency depreciation (3) higher equity valuations (4) lower real interest rates."
How does this help Europe? As the European Commission's Winter 2013 European Economic Forecast notes: "Financial market conditions improved significantly in recent months, but as parts of the EU economy remain in the grip of a balance-sheet recession with adverse financing conditions, private and public deleveraging needs and high unemployment, the transmission of the improvements to the real economy is set to be slow... In particular, the improvement of the financial market situation has not yet impacted on credit growth which is still marked by low demand and tight bank lending conditions to households and non-financial corporations. "
Assuming this assessment largely reflects reality, (4) does not appear to have any meaningful impact on Europe in the short run since it won't spur lending.
(1) will not do much good, expected inflation calculated from 10 year TIPS is 2.54% with QE-infinity and I'm assuming the Europeans won't get a lot more expected inflation if they do QE. 2-3% inflation is probably not enough to help countries like Portugal with 120% public debt-gdp in a meaningful way anytime soon.
(2) is dubious in the eurozone's case, as it is running large current account surpluses with the EUR/USD around 1.3. It appears 1.2-1.3 is a fair range for the EUR/USD for international trade, as large successive current account surpluses appeared in 2012 as well when the currency traded in that range.
QE in the form of ECB purchases of sovereign debt might not even make sense when it comes to countries like Greece, where 90% of the debt is already owned by official institutions like the IMF, EFSF etc.
So I've crossed out the potential positive effects as anemic in the short run and pointed out why QE might not even make sense for the eurozone countries that need it the most. Then why is Bullard making this very public call?
It's the Debt, Stupid!
What's the key thing in a balance sheet recession? Debt, of course! If you could evaporate that debt by saying a few magic words, then the balance-sheet recession would be over. Of course, that's not how it works because moral hazard is a big problem. What arguably got U.S. into this big mess in the first place is because the few magic words cleared up the smaller messes in the past.
My evaluation of the situation is that Bullard's QE recommendation is essentially a call for the EU to cut debt levels covertly. Central bank purchases are rarely unwound. Everyone knows how the monetary base (increases in the monetary base are closely linked with Federal Reserve holdings of U.S. public debt) went like this after 2008:
But that makes it look worse than it is. The actual story going back to 1970 is this:
The Fed has always been increasing its holdings of federal debt! (There are very small declines due to seasonal or liquidity operations or whatever reasons, but those don't matter here.) From 1970 to 2007, federal marketable debt went from $280 billion to $5.3 trillion. In the same period, the Fed increased its holdings by $700 billion, from $55.8 billion, an increase of 1250% when the CPI increased by only 434%.
There were periods where the increase was nil in absolute value, or slower relative to the growth of debt, but it has never been unwound (*there is good reason to think that part of the QE program will be unwound). To a certain extent, Fed purchases can be considered to have monetized a significant portion of the debt. Certainly, this may not have been the intention of the Fed, but it is the actual effect.
So What Does This Mean For Europe?
From 2008 to present, the Fed increased its holdings of Treasuries by about $1.1 trillion, MBS by $1.2 trillion. That is about 14.4% of GDP. Assuming that the eurozone does a QE program on the same scale (let's first ignore its various existing programs), that's about 1.4 trillion euros.
Assuming that the market for ABS is not big enough to absorb that many purchases and all 1.4 trillion euros go into sovereign bonds. If GDP Weights are used, then each country gets a 14.4% of GDP worth of bonds bought by the ECB. Hmm, that's not much for Greece at 157% public debt to GDP, or Portugal at 124%.
But safe assets are getting scarce now right? So what if Germany and France don't use any of their share?(Unlikely, but let's consider the logical extreme first). That means each country gets around 28.8% of GDP worth of bonds bought by the ECB.
|Country||Current Debt-GDP||14.4% purchase||28.8% purchase||Pre-2008 debt-GDP|
Source: Tradingeconomics.com and author's calculations
The people running Greece etc might not be paying their taxes, but I doubt they're stupid. They'll realize soon enough that the ECB won't be able to materially wind down its bond portfolio. So they'll just treat ECB holdings as effectively a debt write-off. These purchases should at least get Italy and Spain back on track to "normal". The confidence boosts would be huge and things just might get going again. This is probably just a can-kicker but the U.S. wants growth and it wants growth now, probably not caring that much about the consequences years later in Europe.
Other than the covert means of QE, there is also the overt option of debt restructuring. Interestingly enough, sovereign debt restructuring is back in the news again lately. The IMF is "Rethinking Role in Managing Sovereign Debt in Crises" (here) which some have reported as "The IMF is considering the biggest changes to its policy on sovereign debt restructuring in over a decade" (here) There has also been media speculation on IMF involvement in a likely inevitable Greek debt restructuring (remember, which is 90% owned by official institutions). Argentina's debt restructuring case may provide a catalyst to spread the debt restructuring meme, paving the way for European debt restructuring.
Based on existing data, my guess is that U.S. economic policymakers want Europe to get back to growth by resolving the debt issues through overt (e.g. restructuring) and covert (programs titled QE that are difficult to understand) methods. Restructuring is too obvious and too controversial and is easier to get done under extreme pressure, i.e. Greece really falling apart. QE is controversial but not obvious. Few people realize that central bank bond purchases historically have essentially had monetizing effects (even if that was not their intention), as the stock of purchases grew but never declined. Through QE, the eurozone can somewhat clear the debt slates, partially resolving the debt overhang situation. What the long term consequences will be is anyone's guess right now, but U.S. policymakers have a strong incentive to press this issue for short term economic benefits. Bullard (and to some extent the IMF) has fired the first shot.
I'll be monitoring the situation closely for future developments. If my analysis turns out to be correct, there will be profound implications for the euro (FXE), European stocks (VGK) and the S&P 500 (SPY).