Eurozone Fiscal Revival Versus The Rise Of Populism

Includes: DIA, IWM, QQQ, SPY
by: Adam Whitehead


The IMF annual conference in Washington switches the global focus from monetary policy to fiscal reform and stimulus.

The IMF's association of weak economic growth with right-wing populism frames the conference agenda.

Central banks and their QE are currently being blamed for the rise of populism.

The Italian bank rescue plan has failed to elicit the desired positive reception from the capital markets.

Helicopter Money is not in the ECB's toolbox, but it is not clear what else is in there if more monetary stimulus is needed.

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(Source: Breugel)

The last report observed the switch in emphasis, away from monetary to fiscal policy, in the eurozone as sentiment grew that the limits of unconventional monetary policy were close. The switch was given a nudge by the OECD's Secretary General Angel Gurria. According to Mr. Gurria, central banks have reached the limits of what they can achieve with monetary policy, so it is time for elected policymakers to take up the heavy lifting.

His thesis was ably supported by OECD Chief Economist Catherine Mann. According to Mann, global growth is so slow that governments will not have the tax revenues to pay their debts. She then advocated that they go further into debt and harmonise these loose fiscal policies globally so that they are all in the same fiscal hole, whilst central banks enable this process with continued cheap liquidity.

The OECD singled out Germany as the nation that should boost investment and productivity in order to sustain its economic momentum. It then issued its latest leading indicators, where growth slows in Germany, US, Japan and the UK. The stall in global growth had therefore been set out for a debate about global fiscal stimulus.

The global switch in focus was confirmed by Europe's premier policy think tank, the Breugel group. Rather than framing the new focus as a consequence of monetary policy hurdles, the perceptions were framed in terms of the utility of fiscal policy. According to Breugel, the European Union might be able to grow faster by overhauling its budget rules to focus on spending instead of structural budget deficits.

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(Source: MarketWatch)

The global debate was then ushered in by the IMF at its annual Washington conference. The economic context was provided by the IMF's latest global growth forecasts, which were lowered considerably from its previous estimates. The political context was provided by the inference that slowing global growth is leading to the rise of right-wing populism.

(Source: CNBC)

Laying the blame for populism at the door of economic growth conveniently took pressure off central bankers, who have increasingly been blamed for the rise of populism in reaction to their unconventional monetary policies. The IMF clearly intended to get central bankers off the hook and put elected policymakers on the spot. In so doing, a balanced discussion of fiscal stimulus and reform was hoped for.

Bank of France Governor Francois Villeroy de Galhau sharpened the new fiscal focus when he said that the eurozone's most pressing reform is to set up a new institution with a finance minister to coordinate national fiscal and economic policies. He should really have said that mutualisation of debt is the objective, if he was to be honest. The enforcement of deeper integration enables the process of debt mutualisation. The line between fiscal stimulus and debt mutualisation is getting blurred in the eurozone.

This blurring must come as a great relief to Spain, which recently published data showing that it missed its debt-to-GDP target for the eighth consecutive year in 2015. If a nation can consistently miss its fiscal targets with punishment replaced by reward, through the ECB's QE buying and negative interest rate strategy, it is a moot point whether fiscal limits are of any practical significance anyway.

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(Source: Bloomberg)

Italian Prime Minister Renzi must also be hoping that this new switch in focus gains traction. Despite a rebound in economic growth, Italy is on the cusp of a showdown with Brussels, as the growth is not strong enough to significantly reduce its debt-to-GDP ratio down to the EU required limit. The recent downgrade to its growth forecast almost guarantees a breaking of the fiscal guidelines.

Traditionally, Italy would have devalued its currency by now, if it were not in the eurozone, in order to cope with the combination of a weak GDP and rising debt. The constraints of eurozone membership, however, preclude this option, thus forcing Renzi to nudge Brussels and the ECB towards the traditional Italian solution.

As the chair position of the process to stimulate the global economy rotated into the IMF's annual conference, the institution began to move its own desired items up the global agenda list. Christine Lagarde took up the cause of fiscal stimulus with a speech in which she trotted out the three familiar risks to global growth; namely the Chinese slowdown, falling commodity prices and the FOMC normalization. Lagarde was however careful to satisfy those requiring economic reforms before turning on the fiscal taps.

The low paid, who are essential to creating higher corporate profits, will be compensated with lower income taxes. Those on social welfare will then be starved back to work in the low-paid cohort by the termination of their benefits. The burden of economic reform, therefore, seems to disproportionately fall on the low paid and underprivileged. One cannot help thinking that Lagarde's remedy plays right into the hands of the populists, who are the antithesis of her globalist agenda.

The IMF also gave a very guarded and qualified opinion on the subject matter of negative interest rates. Whilst accepting that they have reduced borrowing costs and nudged investors out of government bonds into fixed-income risk assets, the IMF pointedly observed that the impact on the banking sector has not been a good one. The IMF sees limits to how long these can be applied without causing unwanted consequences, presumably as a result of their impact on the banking sector. This opinion on negative interest rates provides the perfect prompt for a discussion on fiscal stimulus, which is what the IMF wishes to promote.

Interestingly, Jens Weidmann presaged Lagarde's call for fiscal stimulus with introductory remarks which framed her message. In his opinion, monetary policy is not a growth panacea, and the scope for fiscal stimulus is limited without parallel economic reforms. Economic reform is therefore Germany's price for supporting further fiscal stimulus. The ECB has also been warned not to undermine the pressure for reform or fiscal stimulus by expanding unconventional monetary policy further.

Weidmann then went even further into the offensive with elected policymakers, in an attempt to defend Mario Draghi and maintain cohesion and independence at the ECB. He blamed political interference in monetary policy, which has forced the ECB into its current dilemma of moral hazard through enabling policymakers to avoid making the necessary tough decisions on fiscal reform and stimulus.

Weidmann's comments should also be placed into the domestic German context of a nation facing elections in which populism is vitiating against the status quo that is identified with ECB policies that erode savings and the euro's value.

The calls for a switch in focus may have more to do with the political landscape rather than just economic theory. The rise of populism threatens to unleash regressive economic policies which may hasten the breakup of the eurozone that the populists desire. Political expediency seems to be forcing President Hollande to focus on fiscal stimulus. Labour market reform, which was the basis of his economic reform pledge for 2016, has fallen by the wayside as his popularity decreases.

The story in Spain has parallels to that in France. Flagging popularity encouraged Prime Minister Rajoy to expand fiscal policy to bolster his election hopes. This was only partially successful, leaving the country with a political vacuum in which no major party has a majority. To cover the base, Rajoy then leaked a better deficit number for 2015, which was then proven to be wrong when the much larger real deficit number was recently released. Rajoy's credibility as an economic steward or even a growth creator is now shattered.

Despite all the calls for fiscal stimulus, the ECB is still hedging its bets, and in doing so, sending conflicting signals to policy akers. Peter Praet reiterated that the ECB is prepared to act to boost its monetary policy stimulus if it is required. Such a requirement will exist if elected policymakers cannot come up with a package of fiscal reforms and stimulus. Praet's reassurance that the ECB is still able to provide monetary policy only serves to take the pressure off elected policymakers to find a way towards fiscal stimulus. It also takes any pressure off them to enact fiscal reforms.

In the last report, a catalyst for an unfolding eurozone banking crisis was observed in the new capital adequacy rules from the Basel Committee on Banking Supervision's recently proposed radical changes on how capital adequacy requirements should be calculated. The loss of subjectivity for the banks and the application of a uniform model for capital requirement calculations are expected to force the banks into confessing the true health of their balance sheets.

No sooner had the Basel Committee tried to bring clarity and objectivity than the European Commission (EC) immediately started to protect the banks by diluting the force of the proposed changes. The Commission proposes to adopt the provisions for loss absorption of the Financial Stability Board (FSB) that were announced last November for the most systemically important lenders. The FSB rules are seen as being less onerous than those of the Basel Committee, and more in line with the European desire to promote bank lending rather than to choke it off by making it more capital-intensive. The new EC directive stands in stark contrast with the position held by the chair of the eurozone's bank resolution agency, Elke Koenig. Koenig is far more conservative.

The Bank for International Settlements (BIS) then went on the counter-offensive. Eurozone banks were lambasted for continuing to pay healthy dividends, rather than expand their loan portfolios during the period post Credit Crunch. The eurozone banks have been taking ECB QE liquidity and rewarding shareholders (and their employees who take their compensation through shares), rather than using it for the purpose of lending.

The broken credit transmission can be linked to this act of self-interest. In the BIS's opinion, tighter capital standards through greater retained earnings would place banks in a better condition to weather an economic downturn, and also to enable the ECB's countercyclical QE stimulus to be transmitted to the eurozone real economy.

The BIS has therefore directly identified a facet of the moral hazard that has accompanied the ECB's attempts to stimulate the eurozone economy. Banks have taken QE and rewarded their shareholders and executives, rather than transmitted the economic stimulus to the real economy.

These banks have also systematically undermined their own capital bases, so that they are now unable to withstand an economic downturn. They are now demanding that the ECB support them in their time of need, after they refused to support the ECB's intentions of stimulating the eurozone economy.

The advent of negative interest rates now potentially allows the banks to transfer the source of liquidity that enriches their shareholders, from the ECB to their depositors and bondholders. It is, however, unlikely that their shareholders will be as indulgent as Mario Draghi. Deposits will erode and bank runs may occur. At this point, banks will no doubt ask the ECB to indulge them once again.

The banks are now revealing themselves to be of no use to their depositors, borrowers or the ECB's stimulus strategy. It is now a moot point as to whether their continued existence should be tolerated, if they continue to use the ECB and/or their depositors solely as an executive and shareholder compensation scheme. The eurozone banking model is broken and needs fixing before it becomes extinct.

(Source: Seeking Alpha)

The report entitled "Defining Mr Draghi: Escaped From G20, Imprisoned By The Market, Sprung By The Periphery" explained the phenomenon of the ECB recycling emergency funding from the eurozone core to the periphery. This was characterized as debt mutualisation by stealth.

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(Source: Reuters)

The full implications of this phenomenon are now beginning to be discussed in the media. The perception is that of a north-south divide. There is no incentive for the northern banks to participate in this wealth recycling, from north to south, therefore it will break down as their participation wanes. Their lack of participation spells even greater risks ahead, because these banks are looking at ways to avoid paying the punitive -0.4% to the ECB, which it then itself passes on to the south in the mutualisation process.

The widening north-south divide has sharply focused attention on the parlous state of the Italian banking system. By way of response, Finance Minister Padoan has hastily put together a private sector bank rescue fund to avoid the need for bail-ins of existing debt and equity investors. The most impressive thing about the new fund is its aspirational name, Atlante (Atlas).

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(Source: Bloomberg)

The 5 billion euro fund looks inadequate when compared to the Italian banking system's 360 billion euros of non-performing loans. In addition, the rules governing who will receive the much-needed support are vague and extremely subjective in their interpretation. The rescue fund therefore appears to be dead on arrival, as confirmed by the negative reaction of the Italian equity market on reading the facts. The ultimate unwritten terms of the new rescue fund may thus ultimately involve the bail-in and wipe-out of the incumbent debt and equity holders.

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(Source: Bloomberg)

The issue of Helicopter Money and whether it is in the ECB's toolbox or not has come to the fore in the public domain recently. ECB Governing Council member Benoit Coeure has been prompted to intervene in the debate, opining that the ECB is not currently discussing it. He did not, however, say that it is a tool that will never be used. The way he chose to frame the issue was interesting.

In his words: "To be honest, I don't see how it could work without some kind of risk-sharing with governments, which could be practically and legally problematic". The subject of Helicopter Money is being inextricably linked to the issue of debt mutualisation by Coeure. The current eurozone legal rules on monetary union expressly forbid sovereign debt monetization. Coeure sees that this could be overcome, in theory, by debt mutualisation. The issue therefore rightly belongs with the politicians. The ECB's current debt mutualisation by stealth is therefore breaking the rules, strictly speaking.

Governing Council member Peter Praet, often seen as the major proponent of Helicopter Money, effectively took it out of the ECB's toolbox and placed it in an academic discussion toolbox. According to him, Helicopter Money "remains a sort of academic concept," and "I (HE) can tell you it is not on the table, not even discussed in the Governing Council, even informally."

Praet then went to even greater lengths to dispel the dovish perspective with which he is viewed. In his opinion, negative interest rates that persist for a period of two to three years would be worrisome. Market expectations for the duration of negative interest rates were immediately ratcheted back to a duration of one to two years.

Governing Council member Jan Smets confirmed that Helicopter Money is currently not in the toolbox, whilst trying to assure that the box is still full of tools. This was reiterated by Governing Council member Vitor Constancio.

Market observers, however, are now beginning to conclude that the ECB shot its bolt on significant monetary stimulus at the last meeting, and is now in wait-and-see mode in the hope that this last move has been enough to move the inflation needle. There is also a suspicion that the toolbox is now empty. In order to counter this suspicion, Bank of France Governor Francois Villeroy de Galhau opined that "the ECB is not short of ammunition", whilst avoiding mentioning what this "ammunition" may be.

The release of the latest minutes of the ECB's monetary policymakers' meeting underlined the sense of dilemma in observers' minds over what might be in the toolbox. Whilst broadly agreeing that a monetary policy expansion was needed, the minutes showed considerable difference over the magnitude and form of this signal. The Northern European core of Klaas Knott, Sabine Lautenschlaeger and Jens Weidmann thought the latest policy moves were excessive.

Interestingly, the rate setters agreed with Draghi's view that a tiered negative interest rate structure was impractical to enforce on the heterogeneous and complex eurozone capital markets. A "one-negative-size-fits-all" policy is therefore being bluntly applied, which then manifests itself as a tiered structure because of the aforesaid heterogeneous complexity. The ECB is therefore trying to repair a complex watch mechanism by smashing it with sledge hammer. This negative sledge hammer effectively chokes off the credit transmission process in the banking system.

Bank of Italy governor Ignazio Visco became the latest apologist for this literal ECB bazooka, when he opined that, "Low nominal rates may hurt some financial institutions but they are necessary for the strengthening of growth, raising disposable income and spending, and ultimately inflation."

His failure to acknowledge that negative interest rates actually destroy the banking system and the credit transmission process therefore framed the ECB as being in dangerous denial. Visco believes negative interest rates are justified because the eurozone economy faces a deflationary spiral triggered by second-round effects of the dramatic fall in oil prices. He already sees evidence of this deflationary translation into prices and wages in Italy.

The issue of Mario Draghi trying to enforce a "one-negative-interest-rate-size-fits-all" onto the eurozone was also discussed in a previous report. Draghi had allegedly opted not to go with a tiered negative interest rate structure, because in his opinion, the eurozone capital markets and their instruments are too diverse to make it practical. The report suggested that, in fact, there is already a tiered interest rate landscape in place, which Draghi risks making unsustainable by pressing ahead with further negative interest rates.

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(Source: Seeking Alpha)

The level of floating-rate debt in the eurozone was also observed to be a chief source of risk for the ECB's negative interest rate strategy. Italy was observed to be trying to move its debt profile from floating to fixed-rate in order to avoid buyers' strikes on securities with negative coupons. It would seem that Italy has already reached buyers' striking point in this regard. The Italian Ministry of Finance recently announced that coupons on its floating-rate securities cannot be negative, although they can be zero.

This move by the Italians should be viewed as primarily a hurdle to Mario Draghi's attempts to push negative interest rates in the indebted nations that would benefit from such fiscal support courtesy of the ECB's monetary policy. The corollary effect is that such nations will be forced to reform their economies and reduce borrowing in order to sustain their fiscal positions. Such discipline will come at the expense of economic growth from fiscal stimulus. The north-south divide will then get attenuated. A tiered interest rate structure is therefore being reinforced by market discipline, despite Draghi's attempts to override it.

There is also a growing palpable fear in Germany that the banks will capitulate and pass on negative interest rates to their customers. Beyond this point, it remains unclear how customers will react, although there have been signs that there could be a growing preference to hold physical cash.

Bundesbank Board Member Andreas Dombret does not like what he sees. However, he has been forced to concede that negative interest are more likely to be passed on the longer they persist. From his rhetoric, it can therefore be inferred that negative interest rates are going to remain for some time. The persistence of negative interest rates thus raises German fears over the health and longevity of the eurozone banking system.

German concerns about the eurozone banking system have hardened into a position of outright resistance to the European Commission's proposals to water down European Union (EU) rules on bank capital adequacy requirements. The EU rules were put in place two years ago to avoid the use of taxpayer funds in bank bailouts. Bank losses were to be borne by shareholders. The EC is now attempting to reduce the burden on shareholders and foist it back onto taxpayers.

In addition, the EC also wishes to spread this burden across all eurozone taxpayers through a mutualisation of debt risk. Germany is understandably pushing back against this drift towards mutualisation. As they see it, the risk from the ECB's negative interest rate strategy is now being spread disproportionately from the beneficiaries in the peripheral nations to the core nations through the mutualisation process.

(Source: ECB)

For those who remain fearful of the prospect of Helicopter Money from the ECB despite recent denials, a curious footnote in a recently published ECB research paper started alarm bells ringing again.

This research paper also set the alarm bells ringing in Germany, where it has been assumed that national central bank losses on national sovereign debt would lead to insolvency and recapitalization. The Bundesbank has been anticipating an endgame to the sovereign debt crisis, in which it recapitalizes the ECB after losses on sovereign bonds, and therefore, gains control of the institution.

The research paper suggests that there is another outcome which ensures the existence of the ECB and its current ownership structure in perpetuity. According to the paper, "Central banks are protected from insolvency due to their ability to create money and can therefore operate with negative equity."

The ECB cannot run out of money, because it can just keep on printing it. This finding would seem to imply that there are no limits on its ability to print money. Furthermore, Germany cannot gain control of the ECB and thus put an end to this money creation process. This must be something that causes alarm at the Bundesbank. Germany now needs a plan B to get control of the ECB in the event of another sovereign debt crisis.

The growing negative economic fundamentals explained above did little to increase the risk premium developing in the euro and eurozone asset prices. It took a political fundamental wake-up call to catalyse the developing risk premium process.

The resounding defeat of the proposed EU-Ukraine treaty in a Dutch referendum reminded observers of the limits to expanding eurozone membership. This was then swiftly interpreted and discounted as a shrinking level of existing eurozone nation membership. The combined deteriorating economic and political fundamentals have now switched global attention back onto the eurozone.

As the spark of populism caught flame, Mario Draghi was swiftly on hand to try and put out the flames. Fearing contagion spilling over into southern Europe, he warned Portugal not to roll back the economic reforms it has put in place to date.

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(Source: Wall Street Journal)

Political risk in the eurozone is not limited only to anti-austerity populism. Emmanuel Macron, despite words to the contrary, finally revealed that he is moving to challenge the leadership of President Hollande. Hollande has recently been rolling back the economic reforms that his government put in place on his election victory. Macron has just created a new party named "En Marche". Whilst invoking the words of La Marsellaise, the name also means "work", as well as "advance". The implicit patriotism is also inherent in the party's intentions and capabilities to appeal to both the left and the right.

Macron has cleverly stolen "populism" from the National Front and associated it with economic reform rather than protectionism. In doing so, he has also differentiated himself from Hollande, who has simply copied the protectionist tendencies of the National Front. Macron therefore offers a genuine political and economic alternative.

Just like the Fed, faced with these deteriorating political and economic fundamentals the ECB has been forced into adopting a reflex expansionary stance. Governing Council member Vitor Constancio reiterated that the ECB is ready to do "whatever is needed". ECB President Mario Draghi wrote in the foreword to the ECB's annual report that policymakers won't "surrender" to excessively low price growth.

The dilemma for the ECB is that whilst saying it is ready to act, it has been rather too vague about what it will do when it finally acts. Since Helicopter Money has been ruled out and negative interest rates have been given a two-year maximum duration by Peter Praet, the ECB will presumably press ahead with its negative interest rate strategy. Thus far, however, the jury is still out on negative interest rates. Negative interest rates, therefore, may not be "whatever is needed", so the ECB will have to find something else in its rapidly depleting toolbox.

The debate about "whatever is needed" raged at the last ECB meeting. A larger negative interest rate cut was discussed, but there was clearly concern about the negative impact that this would have on the banking sector. In order to mitigate this impact, exemptions from the passing on of negative interest rates were also considered. It would thus appear that negative interest rates is the preferred policy tool of choice at this point in time.

Germany is swiftly moving to end the debate about "whatever is needed". German Finance Minister Wolfgang Schaeuble has begun the campaign for elected policymakers to pressure their central bankers into withdrawing the monetary stimulus that has been in place since the Credit Crunch.

Doubtless, he is also aware of the political blowback from German savers, who are facing negative interest rates, and who will soon become voters in the country's national elections. It is imperative that Angela Merkel's party is not seen as destroying the nation's currency, in addition to destroying the polity with an open-door immigration policy.

The tactic of blaming the ECB and its policies for fuelling the resentment that has spawned the populist parties in Germany, has already been adopted by some in Merkel's coalition. The IMF has already tried to change this perception. Like his counterpart at the ECB Jens Weidmann, Schaeuble went on the political offensive against these critics under cover of defending Mario Draghi. Schaeuble opined that whilst he may disagree with Mario Draghi's policy, he respects the ECB's sacrosanct independence.

Schaeuble's tactical outburst may be part of a larger strategy to head off the legal challenge to the ECB's OMT programme in the German Constitutional Courts. A victory for this challenge would then open up the tide of resentment against Merkel's coalition and its pro-eurozone agenda. Whilst noting the ECB's independence on this matter, Schaeuble pointed out that any attempt to apply the OMT would be impossible without his agreement. He therefore made the strong affirmation of German sovereignty that the Merkel government needs to deal with the populists.

Going forward, it will be interesting to see if the Germans respond to the calls for greater fiscal stimulus by demanding that higher interest rates are required as the catalyst to trigger capital investment. At this point, Schaeuble can then bend the IMF's calls for fiscal stimulus into a call for higher interest rates and the removal of ECB stimulus.

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.