No Monetary Virgin: The ECB's Backdoor Easing

Includes: DIA, QQQ, SPY
by: James A. Kostohryz

The response of American central bank officials towards the financial and economic crisis in the USA can only be described as pragmatic. The American philosophy throughout seems to have been: If it works, it’s good. Indeed, in managing the financial and economic crisis in the US, the US Fed has not been shy about being “easy.” Indeed, the US Fed has brazen in its implementation of a form of easing known as “monetization: or “monetary financing” whereby the central bank purchases government bonds with money that is newly created. Americans nonchalantly call this “QE” – quantitative easing.

The typical European reaction to this characteristic expression of American “pragmatism” has been a mixture of revulsion and disdain. Judging by their public pronouncements on this matter, many Europeans find the sort of “monetary financing” being performed in broad daylight by American central bankers to be, shall we say -- unbecoming. Indeed, European Central Bank (ECB) officials frequently profess horror at the vulgarity of American policy and rarely miss an opportunity to remind the world that Europeans just don’t do such things.

In official pronouncements, the guardians of the European Central Bank never tire from proclaiming that her “chastity” must be preserved at any and all costs. The discourse of European public officials has been one that emphasizes their commitment to the value of principle over expediency. Indeed, the notion that the immaculate purity of the ECB must never be placed in doubt has it has been publicly upheld even in the face of the potential destruction of the Eurozone.

What should be make of this apparent proclivity of the ECB to “stand on principle”?

Let me apologize in advance if I puncture some balloons: Not much.

ECB is No Monetary Virgin

One may well debate whether there is any “virtue” in the “principle” that a central bank should maintain its balance sheet constant. Many would argue that such a fetish is a vice. However, for the purposes of this essay, this controversy is entirely besides the point. The fact of the matter is this: European monetary “virtue” is feigned. It is pure myth.

The fact is this: Since the end of 2007, ECB total assets have grown from 1.154 trillion Euros to 2.461 trillion euros – an increase of 113%. This is hardly an example of monetary chastity. It could be argued that this rate of increase in the ECBs balance sheet is less than that of the Fed that increased its assets from $893 billion to $2.823 trillion during this same period.

The answer to this objection? Just wait.

The Fed performed most of its balance sheet expansion after the US financial crisis had already broken out in earnest. The Europe has not really even gotten started yet. And the ECB printing presses are only now getting warmed up. Since June 30 of 2011, the ECB has dramatically expanded its balance sheet by an annualized rate of 53%. This compares to an annualized expansion of 2.2% by the US Fed during the same period.

Furthermore, it’s interesting to note the sort of “company” being kept by both central banks in their monetary transactions. By all accounts, the assets being held on the Fed’s balance sheet (and which back the value of the currency) are of a much higher quality than those being held at the ECB. Where as virtually all of the Fed’s holdings are highly rated sovereign debt and high-grade collateralized securities, about half of the ECBs assets are comprised by “non-marketable financial instruments,” PIIGS bonds and relatively low quality Asset Backed Securities (NYSE:ABS). Thus, whereas the Fed has at least been relatively careful with regards to whom it is consorting with, the ECB has been considerably more promiscuous in its activities.

Many readers may ask: “How can this be? Isn’t the ECB legally prohibited from engaging in monetary financing?” The partial answer is that ECB is only prohibited from purchasing sovereign debt directly from national treasuries. The ECB has technically evaded the prohibition against monetary financing by purchasing bonds in the secondary market. But let us just overlook that for a moment and write that off as an extraordinary “exception” to the general principle. The most important thing to understand is that the ECB doesn’t need to engage in this type of overt QE or “monetary financing” in order to expand the monetary base and its balance sheet. Rather than injecting newly created money into the economy directly by purchasing sovereign bonds on the open market, the ECB has been creating money and infusing it into the economy in a more roundabout way -- via injecting money into sundry Europeans banks. The ECB has not only purchased assets of questionable quality from the banks at par value, it has provided financing to European banks in exchange for promissory notes backed by relatively dodgy collateral.

In sum, when looking more closely at the facts, it is quite clear that, the ECB’s purported chastity and its institutional adherence to principle over expediency is entirely imaginary.


Contrary to popular beliefs influenced by the ECB’s constant protestations of monetary virtue, the ECB has consistently engaged in the same sort of monetary easing as the Fed did when confronted with its own crisis. The only real difference is that whereas the Fed openly broadcasts its “easiness” the ECB publicly denies it.

All of this begs the question of what the proper standards are that a central bank should be judged on: We are not concerned with this controversy here. The point we want to make is this: The ECB doesn’t need to announce American-style “QE” purchases of government bonds in order to provide monetary easing. There are many ways it can and does finance the public and private sector with newly created money via the back door.

Furthermore, it is worthwhile to note that the quality of the ECB’s balance sheet has been deteriorating as rapidly as its size has been growing. In other words, its not just the that the ECB is putting out more (money); its increased promiscuity in terms of the types of collateral it will accept means that the quality of its product (euros) is becoming increasingly dodgy. This trend will become greatly exacerbated in coming months. At its most recent December 8th meeting, the ECB announced that it would be relaxing its collateral requirements even further. Obviously, the only purpose for this is so that it can create more money at a faster rate and grow its balance sheet as quickly as possible.

Given the fact that Europe is still in a very early stage in its crisis, it will not be surprising if by the end of 2012, the ECB has put out so much that its balance sheet is larger than the US Fed’s.

The bottom line: Don’t worry about the ECB being so “virtuous” that she does not put out enough. She’s been making the rounds at night, dispensing plenty of action via the back alleyways. And there’s a lot more where that came from.

There are a number of reasons why I am bearish on the overall European situation. However, lack of ways or will for the ECB to inject newly created money into the economy to support both sovereigns and the private sector is not really one of them. This is an important reason why my target for the S&P 500 (SPX) is only in the 950-1,020 range and not lower.

Thus, even though I believe that ECB policy can be and already is far more expansionary and aggressive than many market participants realize, it's my view that all but the shortest-term traders should refrain from attempting to play the equity market on the long side through individual stocks or equity market proxies such as SPDR S&P 500 ETF Trust (SPY), SPDR Dow Jones Industrial Average ETF Trust (DIA) or Powershares Nasdaq-100 Index Trust (QQQ). I believe that investors with longer time horizons should raise cash and avoid purchasing and/or holding equities - even those that appear attractive such as Apple (AAPL), Microsoft (MSFT) and Pepsi (PEP).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.