There are two upcoming U.S. Federal Reserve meetings: July 31-August 1, 2012 and September 12-13, 2012. With high likelihood, we will see another round of Quantitative Easing - or QE.
Economists are split as to whether there would be any real benefit to a third round of QE.
I will present new evidence from a recent survey of 450 U.S. Chief Financial Officers that suggests a new wave of QE will have little or no effect.
This helicopter drop does not solve the Eurozone’s problems: it merely delays them. The ECB is treating the symptoms not the disease.
There is a lull in negative news from Europe. However, it is short lived.
There are four facts that are very important to understand:
We all know that the so-called "stress tests" are not really testing a stressed scenario. The latest round of European stress tests showed a short-fall of €115 billion. [Details ] It is safe to assume that there is a much larger deficit.
It is instructive to look at the indirect evidence.
The difference between spin and reality is stark. There has been so much talk about the ECB being stubborn and not willing to turn on the spigot. The reality is quite different.
The ECB balance sheet has exploded to €2.7 trillion which is approaching one quarter of Eurozone GDP. [Details] This is a bigger expansion than the Federal Reserve undertook in the depth of the U.S. financial crisis. [Fed balance sheet.]
The ECB is also effectively monetizing by making subsidized, three-year, 1% loans to Eurozone banks. This is called Long-Term Refinancing Operations or LTRO. It is simple for the banks to take these loans and then invest in many other assets that are yielding 4% or more. The spread is a direct subsidy to these banks. But many banks are not doing this. They are taking the loan and depositing the proceeds at the ECB (at a rate of 25bps) to "reduce" their risk. However, there are recent reports that they are now using some of the new funds to buy higher yielding bonds.
As mentioned earlier, accepting lower quality collateral is another way of monetizing.
The Federal Reserve is also involved by making it easier for European banks to get access to dollar funding. [Details (subscription may be required)]
A number of months ago I highlighted a story in Frankfurter Allgemeine about the TARGET2 system (which is like the Fedwire system in the U.S., TARGET stands for Trans-European Automated Real-time Gross settlement Express Transfer). Here is a good introduction to TARGET2. See pp. 35-40.
Here is how it works. Suppose a Greek national wants to buy a BMW at €30,000. In usual circumstances, the car buyer goes to his local bank and borrows €30,000 and these euros are transferred to BMW’s German bank. Indeed, the Greek bank would usually borrow the €30,000 from the German bank and deposit the borrowed money into BMW’s German bank account.
However, this doesn’t work anymore. There is no way that German bank will loan money to the Greek bank for this transaction because the Greek bank is known to be insolvent and Greece’s national central bank is not in much better shape.
Enter TARGET2 and the ECB. Let’s follow the money.
First the loan:
Second, let’s follow this through to Germany. (The first three steps mirror the borrowing above.)
For another description of the transactions, see Has the Bundesbank reached its limit?”
Effectively, the Bundesbank is swapping high quality assets (like Bunds) for credits with the ECB. The Bundesbank has racked up a massive amount of ECB credits. Consider the Deutsche Bundesbank’s Monthly Report, Section XI External Sector, Table 9 External Position of the Bundesbank in the European Monetary Union, column 7 Claims within the Eurosystem. (I am being specific here because the English version is published two months after the German version).
Note 1. The German commitment to the European Financial Stability Facility (EFSF) is only €119 billion.
Note 2. The German commitment to the new €500 billion European Stability Mechanism (ESM) is €190 billion.
The TARGET2 balance alone is the size of the entire €500 billion ESM – and it is all from one country. It is a massive back door bailout.
In my opinion, the Bundesbank’s press release in February 2011 is not helpful:
The size and distribution of the TARGET2 balances across the Eurosystem central banks are, however, irrelevant to their risk exposure from the provision of funds by the Eurosystem: TARGET2 balances do not pose specific risks to individual central banks.
To decode, a country’s TARGET2 credit is an ECB liability – not an individual central bank’s liability. In my example with the BMW, the Bundesbank has a credit from the ECB – not the Greek National Central Bank. There is no risk -- if the Euro survives. But that is a big "if". The explosion in the TARGET2 balance is due to the large German trade surplus, German banks’ unwillingness to lend to certain Eurozone banks, and a flight to quality – or run, whereby people from all over the Eurozone want to get their savings into banks in Germany.
The key question for the German public is: "Are you comfortable swapping high quality assets for ECB credits knowing that the ECB has been degrading the quality of the collateral that it accepts? "
Indeed, the Bundesbank is close to exhausting its high quality assets. What is next? The gold stock? Are Germans going to be OK selling gold for credits at the ECB? By the way, there is only €139 billion at the Bundesbank in gold and gold receivables. Given the current run rate, that buys about nine months. [From December 2010 to November 2011, the net Claims within the Eurosystem increased by €170 billion.]
It’s just a matter of time. Collateral will get lower and lower quality. It’s unsustainable.
Putting this altogether, it is no surprise that the Euro has been dropping. The surge in German TARGET2 balances is consistent with a run. The increased credit risk of the ECB is heightening the probability of a run. So all eyes are on the policy makers … and expectations of success on the political front are low.
Now that we have reflected on the (fourth) "historic" EU meeting, the cracks are fully in view. I estimate that it could take years to implement (if everyone agrees) – and Europe does not have years to work this out. Investors realize this and this just fuels the run on Europe.
Let’s first decode what happened at the EU Council. Statement found here.
The centerpiece of the agreement is a " fiscal compact". The essential items are:
Not much. Items 1-3 simply restate what is already in the Financial and Stability Growth Pact of 1997. Importantly, very few countries have taken these rules seriously. Currently, 13 of 17 Eurozone members are offside – including Germany. Greece has been serially offside. Indeed, there is only one country, Estonia, that is running a fiscal surplus!
The automatic sanctions are new. In addition, they are not very automatic. A country is called offside. A plan is presented and then a second vote is taken with the European Council. Two votes. In addition, a 2/3 majority could override the sanctions. If there is a problem, you go to the European Court of Justice. Who knows how long it will take there. To me, this is not "automatic".
The approval of bond offerings before the fact, i.e. "ex ante", seems very similar to the "automatic" sanctions. I am not impressed.
The basic idea is that enforcement would come from the European Council –and eventually through the European Court of Justice. However, not all countries are on board. Indeed, the U.K. vetoed.
Hence, you have the dysfunctional situation of the ECJ enforcing rules on some countries in the EU but not others. It is a legal nightmare.
David Cameron has taken a lot of heat. However, his decision to veto, in my opinion, was a no brainer.
The financial services industry is crucially important to the U.K. economy. Agreeing to the EU proposal would have put this industry at great risk.
The EU is pushing a so-called Tobin Tax – or transactions tax. While no big deal for markets in Europe (they are relatively small), it would be devastating for London – the world’s leading financial center. Even a small transaction tax would see investors choosing to trade in New York, Singapore or other markets that have no transactions tax. It would be crushing to the UK economy. I understand Cameron’s veto.
Will the UK become isolated? Yes, but they are already isolated. It is really no big deal. The key for the UK is to protect their growth opportunities and you can’t do that if you seriously wound your leading industry.
Another hurdle to the agreement is to implement legislative and/or constitutional change in each EU country to recognize the balanced budgets. This is probably a good thing (i.e. fiscal discipline written into law – because it enables lawmakers to deflect blame when they vote against spending increases). However, it will not be so easy to implement.
There are two main problems: France and Germany. I don’t think it will be easy for either country to approve this and they are the nexus of the EU!
In France, it is an issue of yielding sovereignty (effectively to Germany). This is enormously unpopular – and could be the election issue that brings down Sarkozy. Check out the statements from Marine Le Pen who would take France out of the Eurozone. [In French]
In Germany, the basic story is very similar. They need to amend their constitution. The German Federal Court decision in September made it very clear that any extra-sovereign control over budgets was unconstitutional. Hence, changing the German constitution is the only option. However, it is naïve to think this is easy. The rank and file in Germany is very nervous. They believe that this is a prelude to a " transfer union" – where the Germans are in a continual state of bailing out weaker EU members. Put bluntly, Germans are working to age 65 or 67 before retiring – but they are funding Greeks (and potentially other countries like France) that are retiring at 55. Not fair. Not popular. And naive to think that the Chancellor can wave her wand and make this happen.
In addition, I think the German public will be furious when they fully understand that they have almost single handedly been bailing out the periphery by selling their high quality assets for ECB credits. At some point, enough is enough.
No.
It is true that Germany has done well with the Euro. They are the strongest economy in Europe. They have hugely benefited from a cheap Euro. Their trade surplus is 5.7% of GDP – which is even bigger than China’s 5.2%.
However, we know there are no free lunches. Now, is the time to pay the price.
Germany is in an awful lose-lose-lose situation.
They are a loser if they have to single handedly continue to bailout the peripheral countries. Frankly, who else can afford to do it? The next three biggest countries in Europe - France, Italy, and Spain – certainly cannot contribute in a big way. The latter two are recipients! The UK is on the sidelines. But
Germany does not have unlimited resources. Remember they are offside already on the debt to GDP measure.
They are a loser if the ECB continues to monetize. This likely means future inflation which is simply a tax that especially hurts Germany - not just because it is wealth, but because of their history and the country’s extreme aversion to inflation.
They are a loser if the Eurozone breaks up. A new Deutschemark or new Euro based on subset of strong countries, would soar in value. This would be devastating for the export sector (which is 46% of German GDP). In a previous blog, I speculated that German could lose half of its exports on a revaluation. While export revenue might remain the same (if the value of the currency doubled), it would be devastating for certain industries – and lead to severe unemployment – another thing that Germany has a strong aversion to.
To really answer the question of whether Germany is better off under the Euro, let’s explore a recent parallel example – the U.S.
The Federal Reserve maintained a policy of very low interest rates – on a real basis, negative interest rates, for an extended period under former Chairman Greenspan. The result of this policy was an economic boom largely driven by construction and housing. Consumers were refinancing their mortgages at lower rates and doing "mortgage equity withdrawals" (increasing their mortgages and using the extra money to spend). The U.S. is now paying the price for this structural dislocation. The U.S. is facing a ‘lost decade’. Is the U.S. better today off as a result of the cheap interest rate policy? No.
Now to Europe. Countries like Greece, Italy and others were faced with the ability to borrow at very low (German) interest rates. They exploited this cheap financing – just like the U.S. construction industry did. Germany was booming with exports and running a massive trade surplus given the cheap exchange rate.
Now they realize that there is a price to pay. It is not the question of are they better off right now. You need to factor in the future costs.
Let me try to navigate through the mess in Europe.
Do you hear that ticking sound?
Today it was leaked that the Federal Reserve has requested a "contingency plan" for Bank of America (BAC). Supposedly, this includes the possibility of spinning off Merrill Lynch for some extra cash.
Such a request for a plan is extraordinary. It proves that the Fed’s so-called "stress tests" are flawed. What is the difference between "if business conditions worsen" and the "adverse scenario" of the stress test?
I will argue that the flawed stress tests have given the public, regulators and the banks a false sense of security. As a result, the banking system is unprepared for a realistic adverse scenario.
It makes sense that there is a secret group within the Deutsche Bundesbank working on a plan to resurrect the Deutsche Mark. It would be a gross failure of national risk management if they did not have a plan. Call it Operation Vollkreis.
Continue reading "Bundesbank Special Ops Group (Will the Deutsche Mark Reappear in 2011?)" »
Put simply, QE2 does not address the fundamental problems that the U.S. economy faces. It is preposterous to think that reducing medium term interest rates by 25-50 basis points is going to lead to a significant increase in U.S. GDP and a reduction in unemployment.
After much anticipation, the second round of quantitative easing - QE2 - was announced November 3, 2010. Indeed, there was very little surprise. Market participants had expected $500-$700 billion of bond purchases and the Fed announced $600 billion. These purchases will happen on a regular basis through June of 2011.
It works in the following way. The Fed will be in the market buying Treasury bonds mainly in the 5-10 year range. The $600 billion size means that the Fed will be effectively buying most of the newly issued Treasury debt in this maturity range. This is in addition to the purchases being made with the income and maturing bonds from the first round of QE. This increases the amount of buying to approximately $800 billion.
The Treasury needs to issue debt to finance the sprawling fiscal deficit. The Fed buys the debt. It is added to the balance sheet as both an asset and a liability. In the end, the Fed's balance sheet will grow to a staggering $3 trillion which is 20% of GDP ($3 trillion/$15.03 trillion - projected 2011Q2 GDP assuming 3% nominal annualized growth). The 20% of GDP puts us in an exclusive club -- second only to the 23% held by a country with a great monetary policy track record -- Japan.
There is a secondary effect. As U.S. interest rates go down, the U.S. is presumably less attractive on an investment for foreign fixed income investors. This may put downward pressure on the exchange rate. A cheaper exchange rate means that exports are more competitive and imports are more expensive.
Of course, the Fed has to do something. Their mandate includes both price level stability as well as full employment.
In the first round of quantitative easing, the Fed used bullets. There were many innovative programs that addressed the financial crisis. Short-term interest rates were dramatically driven to zero. The short-term interest rate tool is not available any more because interest rates can't go negative. Hence, other types of ammo are being used - and this ammo is far less effective.
Some of my colleagues have written a paper on the impact of a $500 billion QE. It is available here. The impact is likely in the range of 25-50bp. Some of the impact is already incorporated into the bond prices because the size of the QE was highly anticipated. It is really unlikely that 25-50bp in medium term interest rate yield reduction will have a sizable impact.
So what if mortgage rates are reduced by 25 basis points. Will this breathe life into the housing market? Very unlikely. Rates are already cheap. People don't want to buy a house because they know that there is both a huge inventory of unsold houses today and another wave of shadow inventory coming in the future as foreclosures continue. The risk of housing prices going down further is massively more important than a mortgage that is 25 basis points cheaper. Furthermore, there is a huge number of consumers that cannot refinance and take advantage of cheaper rates because they owe more on their mortgage than their house is worth. That was true before QE2 and after.
It is possible that there is a trickle down effect whereby consumer credit rates are reduced a little bit. Again, consumers are worried about the decreased value of their housing stock, their ability to hold onto a job, and, eventually, building up their savings. This is not the time to go on a consumption binge.
U.S. firms are sitting on $1.5 trillion in cash. The Duke-CFO survey showed that these firms are unwilling to deploy the cash because of: 1) uncertainty in the economy and 2) they were afraid that their usual method of financing (through banks) might dry up in a second leg of the credit crisis. QE2 does not address either of these problems.
While some corporations are sitting on cash, there are many corporations that need financing for quality projects -- yet they cannot get this financing. The Duke-CFO survey showed that for small and medium sized businesses credit conditions deteriorated for more than one third of them - compared to 2009. These firms have projects that they deem high quality that will help economic output and increase employment - yet they are refused financing. Why? Right now, there are many banks that are in survival mode. There are more than 400 banks on the FDIC watch list and many more that should be on the watch list. In my opinion, the best way to get the financial system back to healthy condition is to purge these weak and often zombie banks. Their quality asset would be assumed by strong banks making them stronger. The FDIC would have to unwind all the garbage. Everyone knows that small and medium sized businesses are the drivers of growth and employment. Why is it that so little attention is paid to the fact that they are still in credit crisis mode?
Yes, it is true that lower interest rates would usually put downward pressure on the U.S. dollar. Indeed, the trade weighted dollar has already declined. However, there are some countervailing forces. First, the U.S. is still the safest place to invest. Europe is not very attractive and few want to touch Japan. Second, there could be action by other countries that could mute the effect on the exchange rate. Third, the reduction in rates is so small that I seriously doubt the effect on the dollar would be meaningful.
In 2003, interest rates were driven to 1% (which was a huge negative real interest rate) by the FED because employment was slow to come around after the end of the 2001 recession. We all know what disastrous consequences this policy of not just cheap - but subsidized - borrowing caused. Financial institutions levered up with the subsidized funding. Consumers did mortgage equity withdrawals as they refinanced at below market rates. Housing prices went crazy. I think that most economists would agree that the Fed has much more power over inflation than employment. Yet part of their mandate is full employment. The latest policy is aimed at employment (though cloaked with concern about inflation being too low). It is best for the Fed to focus on inflation.
The good news is that the Fed is only doing $600 billion in QE. It could have been worse -- like $1 trillion.
As you know, I have long been an advocate of short-term pain to build the foundation for longer-term gain. Right now, we are treating symptoms rather than the underlying problems.
The only way to do this is to do a painful purge of our financial system. There could be 1,000 banks that need to go down. We need to end the "extend and pretend". We need to shutter the weak and reallocate their good assets to the strong -- to make them stronger. The bad assets would be unwound over a number of years by the FDIC. This would make our financial system much more secure and increase the chance that quality projects get funded. This, in turn, leads to higher growth and higher employment. We have twiddled our thumbs for three years making only incremental changes. We have very little to show. Our financial system is still broken. Well, let's try to fix it - and lowering medium term interest rates by 25bp does not fix it.
While it is painful, foreclosures must increase. It does not make sense that people who have not paid any mortgage payments since 2007 are still in their (or the bank's) house. Yes, I know that some were misled by banks - and hopefully changes in lending practices will reduce the chance this happening again. Yet many, many others, brazenly did mortgage equity withdrawals (increasing their debt) thinking that the housing prices would continue to rise. Houses are just like any asset. They are risky. The risky bet did not payoff. The overhang of all the future foreclosures is paralyzing the housing market. Better to get it over with.
This is not some sort of U.S. political endorsement - unless you think Chancellor Angela Merkel is a Tea Partier. I am talking about the type of tough policies followed by Minister of Finance, Paul Martin in the 1990s. Do you notice the divergence of approaches between the U.S. and Europe and Canada. Canada made many of the tough choices before the crisis and we all saw the results. Europe is now going into austerity mode. Many in the U.S. are calling for another round of fiscal stimulus - in addition to the QE2.
The main problem we face is economic uncertainty. Much of that uncertainty is driven by the massive imbalances. There are two big ones. First, the U.S. government fiscal deficit is running on an unsustainable course. Bold, bipartisan action is need to put our house in order. Second, there are staggering unfunded liabilities in terms of social security, medicare, and government pension plans. The net present value of these liabilities are many times the current U.S. GDP. Again, this is not sustainable and policies must be changed.
Given there is little political will to make tough choices that are good for the long run but painful in the short run, we are stuck.
How do you explain world stock markets rising 2% after the QE2 announcement? I think there will be some sober second thoughts. QE2 does not address the fundamental problems.
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Whether it is Basel 3 or the Dodd-Frank bill - or the projected increased share of government in the economy, we need to understand the impact of regulation. The following is a summary of my remarks to a Finance Symposium on Regulation.
There is a fundamental structural issue that should not be overlooked. The U.S. has 7,830 FDIC insured banks. There is no good economic reason for 7,830 banks. They exist because of the legal structure in the U.S. Some banks are federally chartered and some banks are state chartered. It creates a regulatory nightmare.
If the U.S. is going to competitive in the global banking landscape and hope to have effective regulations, we need to seriously re-examine a basic structural issue. All banks should be federal.
Currently there are 829 banks on the FDIC watch list. We hear about "extend and pretend" strategies being pursued by many banks. The Duke CFO Survey in September showed that 30% of small and medium sized businesses considered credit conditions worse now than a year ago.
The financial system will have difficulty facilitating growth in the economy until we purge the weak banks. These weak banks are denying loans to businesses that present them with good projects -- projects that could increase employment well into the future. Purging the weak banks also has a positive effect on the other banks. High quality assets are usually redistributed to strong banks making them even stronger. Instead of the usual Friday announcement of a handful of failures - let's get it over with quickly.
There are two ideas, in particular, that deserve some extra discussion. The Basel 3 does not provide details on these ideas but they are in the mix.
The first is the idea of having stricter capital requirements for banks that pose systemic risks. Essentially, a bank is penalized for being too big and, as a result, there is an incentive not to become too big. Of course, the problem is where do you draw the line. In the U.S., the list of banks that pose systemic risk is fairly clear. However, what about other countries? One can imagine country A's banks complaining to country A's regulators that they are operating at a competitive disadvantage to country B's banks because the country B did not deem their own banks systemically risky.
The second idea is that of a counter-cyclical buffer. This is unambiguously a good idea and I wish it had been part of the package released this week. The idea is that in good times banks must build capital reserves over and above the usual levels. When a recession arrives, they can dip into the buffer. One of the main problems with the current financial crisis was that banks were undercapitalized. Extreme (and flawed) measures like TARP had to be implemented at great cost to taxpayers. The countercyclical buffer essentially means that the banks need to put more of their profit into a rainy day reserve in good times.
The Duke-CFO Survey tried to examine why U.S. firms were sitting on $1.845 trillion in cash (Federal Reserves's Flow of Funds report). Part of the problem is the lack of faith in the financial system. Many firms are hoarding cash because they fear a second wave of the financial crisis. In addition, there is considerable policy uncertainty (both regulatory and economic). 50% of firms have no intention of deploying that cash over the next year.
On the other side, financial institutions have about $1 trillion in excess reserves sitting at the Fed earning 25 basis points. Ideally, some of this cash should be deployed to loans to businesses. However, financial institutions - with the same mindset of the CFOs - perhaps believe this conservative strategy puts them in a stronger position if a second financial crisis unfolds.
We also asked the CFOs about Dodd-Frank. Only 4.9% had a positive view. The 4.9% strips out financial institutions - which had an even more negative view. You might think that the low proportion is biased by political views. I am sure that is a factor -- but it cannot explain 4.9%.
Why don't they like it? Mainly two reasons.
First, the implementation induces a lot of policy uncertainty. There is a lot we don't know about how this massive bill will be implemented. The bill provides a framework. Implementation will determine the new regulations.
Second, CFOs are worried about the cost of debt increasing. Higher cost of debt means that fewer projects have positive present value. It means less investment and lower growth opportunities.
It is simple.
Too little regulation and things can get out of control. For example, many painfully learned during the financial crisis that large parts of the financial system were completely unregulated.
Too much regulation can hurt the entire economy. Financial institutions become more conservative and effectively increase the cost of debt for corporations. This leads to less investment. The group of businesses hardest hit are the small and medium sized businesses. They are deemed more risky because they are small and often relatively new. In most cases, there is less of a track record for the small business. However, these are precisely the businesses the generate the bulk of the jobs in the U.S. economy. If we make it more difficult for them to borrow, this substantially hinders future job creation.
There is no doubt that financial institutions need to be regulated. Given all the guarantees (like explicit FDIC and implicit too big to fail), many would argue they are already quasi-government institutions. However, we need to be very careful not to cross into a territory that destroys future growth opportunities.
One of the reasons that the U.S. economy has been so successful is that the financial system has facilitated ideas to production. That is, if you have a great idea, you can go to a venture capitalist or a bank and get a loan. The loan is risky but the project gets financed. Implementing these ideas leads to jobs. In the end, many of these ideas are failures. Yet some are big winners driving both returns for shareholders as well as opportunities for employment. Regulation can impact the propensity to innovate in an economy. This cost is difficult to measure and is long-term in nature. However, it must be considered.
It doesn't feel like the recession is over.
The Business Cycle Dating Committee of the NBER announced on September 20, 2010 that the U.S. recession officially ended in June 2009. The Committee looked at a number of indicators. This is the list from their press release and in parentheses the trough date for each:
The website provides the data an graphs of each series. I have some reactions.
Let's go through the long list that paints a picture of both short-term and longer-term risk to the U.S. economy.
Yes, Canada is in way better shape than the U.S.
However, the U.S. is the single most important growth factor for the Canadian economy. To fully understand Canada's prospects, you need to understand the U.S. prospects.
What about the good news? Uhhh... Maybe your favorite team advanced in the World Cup?
I have some other thoughts.
Cam Harvey is professor of international business at Duke University in Durham, North Carolina. He is also the editor of the Journal of Finance and author of an online glossary of financial terms.
A native of Toronto, he has served since 1992 on the Board of Directors of Torstar, parent company of the Toronto Star.
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