Waiting for Europe’s QE to sail
The good news is that the European Central Bank will probably start a massive additional round of quantitative easing to fight the break-up of the euro zone.
The bad news is that they will, as ever, only choose the right policy, as Winston Churchill said of the Americans, after exhausting all of the alternatives.
Global share markets rallied furiously on Wednesday, fed by hopes that the ECB would increase its bond-buying efforts, a possibility raised by its chief Jean-Claude Trichet in an appearance before the European Parliament. Trichet faces stern opposition inside the ECB from fellow central bankers, notably German Axel Weber, who believe that policy should be normalized rather than loosened.
This opposition, in combination with an unsure political climate, means that euro zone authorities will probably continue to try to buttress, enlarge and formalize the bailout mechanism while trying to maintain the fiction that something approaching normality reigns in European money and bank funding markets.
Why would QE be used to fight the break-up of the euro zone, now being widely discussed as the crisis spreads to ever larger member states?
Because QE, or really we should simply call it the monetization of government borrowing, offers some hope of easing the austerity now being imposed on Ireland and soon to come in Portugal and Spain.
Europe has made a choice to not allow member states to default or to allow their weakened banks to default, as default would threaten banks elsewhere. That leaves weakened economies carrying a crushing amount of debt, debt they will attempt to repay by budget cuts. This is a recipe for an economic death spiral, as a smaller and smaller economy becomes less and less able to shoulder its debt service.
Without their own currencies to devalue, the weak of Europe have no other safety valves.
While QE is genuinely dangerous, it will ease conditions and can be directed at peripheral bond markets.Default is a better option, but Europe is unwilling to go there, at least not yet.
So, QE it will be, but the issue becomes when and how large.
“If the political masters in Europe wish to maintain the status quo then the answer lies in the monetization of debt. The ECB, with the ability to print money, can support the market by buying government bonds,” Stefan Isaacs, of fund manager M&G Investments, wrote in a note to investors.
“However what is needed is ‘shock and awe’ rather than tentative, reactionary responses, if indeed the ultimate goal is to support the euro in its current guise. That said, I’m not convinced that an about-turn is likely any time soon. The hawks in the ECB remain, for now, firmly attached to their mandate of price stability.”
EUROPE LOOKS FOR A BAZOOKA
For now, the ECB is likely to do what it can by way of bond purchases and liquidity support while temporizing over the pace and scale of returning the system to normality.
The focus of action, then, will be on increasing the size and prestige of the European Financial Stability Facility, created in May and so far employed to help both Greece and Ireland. ECB council member Weber suggested in November this could be increased and there have been some indications that both the euro zone and IMF are discussing this.
This strategy is appealing to Weber and to others in Europe because it emphasizes euro zone strength and resolve, taking real money and lending it to allow member states time to pay back their debts, rather than printing up a mess of inflation and euro weakness to ease the pain.
A muscular strategy, but also a failing one. The 750 billion euros was meant to be big and intimidating back in May, but now looks paltry. If Spain needs help would 1.5 trillion euros look much better? Not if the debts of the weak Spanish regional banks are not partly extinguished. The same math of austerity and growth that applies now to Ireland will apply to Portugal and Spain in time.
So, QE, preferably large, from the ECB, but likely not until they are pushed early next year.
If this happens, or rather as its likelihood rises, it will drive a massive rally in risk assets and drive even more liquidity to Asia. Many investors will be giddy that the ECB and Federal Reserve are both driving asset prices higher, while a substantial minority, fearing inflation, will flee government debt and buy energy, commodities and gold.
The big loser, in the near term, will be China, which will have to eat European- and U.S.-exported inflation and will fret over its trillions in euro and dollar reserves.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. email Saft at: firstname.lastname@example.org)