- Draghi adds anticipated stimulus.
- Increased lending to subprime credits undermines repair of European bank capital levels.
- Failure to weaken the Euro could lead to currency war policies.
- Excessive and growing debt will ultimately penalize investors.
In 2008, the world was on the edge of financial collapse when banks were so suspect of each others' balance sheets that they would not lend to one another. Almost all were massively overleveraged and required unprecedented intervention by U.S. monetary authorities. Suffering only a few casualties, the banking industry was saved from its financial miscalculations - even rewarded after the initial rescue with essentially free money with which to profit from Fed-supported U.S. Treasury investments.
Notwithstanding the most aggressive central bank stimulus program in history, the U.S. economy continues in the most sluggish recovery from recession of the post-WW II era. Most of the rest of the world is similarly slogging through a barely perceptible recovery. To break out of a quarter-century long economic malaise, Japanese monetary authorities have thrown all caution to the winds. They are currently adding debt to their central bank balance sheet in even greater amounts than is the U.S. Federal Reserve. Theirs is a life or death survival bet on huge amounts of additional debt solving the problems created by too much debt in the first place. With Japan as its third largest member, implications for the world economy are huge.
Enter Mario Draghi. In a much anticipated announcement, European Central Bank President Draghi unveiled a collection of monetary measures designed to weaken the Euro, boost inflation and revive a Eurozone economy struggling to remain above recessionary levels. To promote bank lending, the ECB has introduced a negative interest rate of 0.1% for funds held as deposits. Because the amounts held on deposit at the ECB are relatively small, this provision is more symbolic than economically important. It does, however, underscore the urgency with which the bank is attempting to encourage lending.
A major problem for European banks is a lack of loan demand from qualified borrowers. The ECB finds itself in the unfortunate position of having to promote more lending to boost economic activity while simultaneously pushing banks to shore up their still precarious capital positions. In fact, after years of central bank support, European banks have just recently brought their leverage levels down into the mid-twenties, the level where U.S. banks were just before the 2008 crisis. The banks certainly can't afford to add debt that bears any appreciable risk of default, which calls into question the wisdom of easing collateral rules as part of the ECB's current stimulus program.
Market prices and currencies immediately reacted favorably to Draghi's Thursday announcement and press conference. As the day wore on, however, stock price gains fell from their highs. Worse yet, the Euro actually ended higher on the day, calling into question the ultimate effectiveness of these extraordinary measures. No one wants a strong currency in today's environment of weak worldwide demand. Should efforts like these not produce their desired ends, it is likely that the ECB and other central banks will resort to even more aggressive programs to weaken their currencies, pursuing "beggar thy neighbor" policies similar to those that contributed mightily to global economic contraction in the 1930s.
As I have frequently discussed, excessive debt is an insidious problem, leading ultimately to a great many negative economic and securities market outcomes. So far, central bankers have succeeded magnificently in convincing investors that everything is under control. Sooner or later, if positive results are not measurable on Main Street as well as on Wall Street, that confidence will wane.