Erik Norland, Senior Economist, CME Group
Blu Putnam, Chief Economist and Managing Director,
Strategic Intelligence & Analytics, CME Group
There is a deep sense of pessimism that pervades Europe. The European Central Bank (ECB) move to enter into a large asset purchase plan (i.e., quantitative easing or QE) reflects the general sense that fighting deflation and stagnation is priority number one. Some of the pessimism is no doubt warranted, yet our perspective is that it may be overstated, and that the 2015 economic outlook was mildly positive before the ECB move and now, perhaps, even a little more so.
One of the less appreciated influences on the economies of the Euro-Zone in 2014 was the unintended consequences of the bank stress tests, whose results were announced by the European Central Bank (ECB) in October 2014. Those stress tests led to a major focus on the banking sector in 2013 and 2014 on cleaning up balance sheets and improving capital ratios. The result was a credit crunch, a poorly functioning financial system, and no economic growth – at least on average in the region. With the stress tests in the rear-view mirror, 2015 should look better for the credit system, especially since the European Central Bank (ECB) seems committed to its version of asset purchases (i.e., quantitative easing).
We are not overly optimistic that the ECB’s large-scale asset purchase program will provide much directly help for Euro-Zone economies. The ECB’s program will, however, remove some worries about credit spreads in the sovereign bond market and may also help keep the euro relatively weak, aiding in the battle against deflation.
And, while Greek politics can be unsettling, we would caution against worrying too much about a Greek exit from the euro. Political rhetoric aside, we would put the probabilities of the Greek’s leaving the euro at around 10% or lower. If the Greeks do choose to leave, the euro may rally, while the Greek economy experiences hyperinflation in new-drachma terms. . And yes, the ECB and other Greek creditors will be hit hard The ECB, at least, will be able to absorb the impact. If the Greeks stay in the euro, then they will need some more financial assistance, but the economy has already made the bulk of the long-term adjustments it needs to achieve a modest amount of stability.
Economic drag from banking system stress tests
The extent of the banking system’s balance sheet clean-up and capital ratio improvement can be seen by reflection in the balance sheet of the ECB. While the Fed and the Bank of Japan were expanding their balance sheets in 2013 and 2014, the ECB saw a major contraction. This occurred because the ECB had mainly utilized emergency liquidity loans to the banking system as its form of support in the years after the 2008 financial crisis and during the sovereign debt crisis. The ECB had promised a tough test this time around, and no bank wanted to be the one that failed. Banks looking to pass the stress tests with flying colors were quick to appreciate that the line on their balance sheet marked “emergency liquidity loan” did not look good and needed to be repaid. And, repay them they did – instead of making new loans or extending credit to support economic growth.
The stress test period is now in the past. All the major banks passed, although some needed to raise some additional capital. More importantly, for 2015, the credit system will no longer be focused on balance sheet clean-up and can resume a more traditional approach to risk-based lending activities. We do not want to overplay this point. Yet, removing a big obstacle from the past can set the stage for incremental improvement. Improving credit markets may allow for real GDP growth to move modestly into positive territory, say the 1.0% to 1.5% range, with or without further help from possible ECB asset-backed securities or bond-buying programs.
Greece represents 1.9% of the Euro-Zone nominal GDP. The largest creditors to Greece are now the ECB and the European Financial Stability Facility. If Greece exits the euro, these two institutions take the losses, and while they will not like it, they can afford it. Moreover, the Euro-Zone would be much stronger without Greece. Remember, the main reason Greece was so interested in joining the Euro-Zone was so it could keep Turkey out. Neither Greece nor Turkey are good fits, in economic terms, for Euro-Zone membership. Despite some acrimonious political rhetoric, our base case is that Greece stays in the Euro-Zone, and that its bark is much worse than its bite. If Greece were to create a new drachma, hyperinflation would not be far behind.
The other factor supporting a return to modest economic growth in 2015 is the lagged impact of the depreciation of the euro. As it became clear that the Fed was ending QE and the US rate-rise debate was commencing in the context of a healthy economy, the comparison with the ECB’s likely return to asset expansion and Euro-Zone’s laggard economies put downward pressure on the euro. The trend for euro depreciation versus the US dollar may continue, assuming healthy US growth and ECB moves to embrace quantitative easing and asset purchases as a way to counter deflation fears.
We also note that while the ECB might not be publicly supporting a weaker euro, its policy path and embrace of quantitative easing strongly suggests that allowing a weaker euro is the primary defense against deflation. Surprises, though, are always possible, including better-than-expected European economic growth or unexpected delays in the Fed rate-rise decision. Put another way, trends always look clearer in the rear view mirror, and some volatility or curves in the road may well lie ahead, even if the overall trend remains in place.
Debt and the Downside Risks to the Euro-Zone Economy
Debt is still a major issue in the Euro-Zone. While the ECB’s promise to save the Euro “at any cost” and its low interest rate policy have succeeded in reducing borrowing costs for Ireland, Italy, Spain and Portugal to manageable levels, Greece is still an issue, as noted above.
On a broader basis, high levels of debt remain a downside risk for other Euro-Zone economies as well. The Netherlands and Ireland have elevated levels of household debt at 126% and 102% of GDP, respectively. Likewise, Ireland also has a deeply indebted non-financial corporate sector with debts adding up to 216% of GDP. Belgian and Portuguese corporations aren’t too far behind with debt equivalent to 192% and 163% of GDP, respectively.
High debt levels could constrain growth in many Euro-Zone countries. Ironically, it is not the Euro-Zone’s overall debt level which is of concern. In fact, the Euro-Zone overall has slightly lower leverage ratios than the US or the UK. The problem is the distribution of the debt. It tends to be highly concentrated in the countries with the highest borrowing costs (Greece, Ireland, Italy, Spain and Portugal). Meanwhile, Germany, the nation with the lowest borrowing costs, brings down the Euro-Zone average significantly with its low levels of private sector debt. These disparities are at the center of much of the wrangling over quantitative easing on the part of the ECB. Germany opposes it, with the indebted nations in favor.
What is curious is that seven years of economic crisis in the Euro-Zone have failed to lead to a deleveraging of the economy. Essentially, public sector debt to GDP has risen, offsetting a decline in private sector debt to GDP. So long as the ECB continues to maintain an easy monetary policy, servicing this debt burden should not be a problem outside of Greece. That said, it will likely restrain the pace of economic growth and may make the more heavily indebted Euro-Zone economies more vulnerable to shocks. Moreover, if the nominal GDP grows more slowly than the cost of servicing the debt, then the debt-to-GDP ratio may continue to rise. Robust nominal GDP growth of 3% or more would permit a successful deleveraging of the Euro-Zone economy, but that is not in the cards, at least in 2015.
Commodity Price Induced Deflation Is Not a Bad Thing
The collapse of oil prices has pulled the Euro area into deflation in the short term but the risk of long-term declines in prices à la Japan are fairly limited. Core inflation remains at 0.8%, low enough to justify the QE policy that Mario Draghi has planned for the ECB. A weaker Euro should help to prevent the core inflation rate (excluding food and energy) from going negative year-on-year. Moreover, the decline in oil prices will give a significant boost to Euro-Zone consumers and to the Euro-Zone economy in general. The Euro-Zone produces essentially none of its own petrol. As such the decline in crude prices coupled with a weaker euro should boost the Zone’s trade surplus with the rest of the world, leading to enhanced competitiveness and export growth. The collapse in oil prices and a weaker currency should help to offset some of the downside risks mentioned above.
Will the ECB’s Version of QE Help?
All of this brings us to the policy question de jour – namely, whether the newly announced asset purchases (QE) by the ECB will do much to help growth. We will weigh in with our take on this key question.
For QE to work, it matters what assets are bought. Central bankers seem to think buying government debt can help the real economy grow faster. We do not think so. Interested readers can see our scholarly contributions on this subject: "Essential concepts necessary to consider when evaluating the efficacy of quantitative easing." Review of Financial Economics 22.1 (2013): 1-7; and “Evaluating different approaches to quantitative easing: lessons for the future of central banking,” Journal of Financial Perspectives, Volume 2, Issue 2 (2014).
When a central bank buys its own government debt or, in the ECB’s case, the sovereign debt of its member states, government spending does not increase. Not in the US, Japan or the Euro-Zone is there a link between monetary and fiscal policy. And, if the asset purchases by the central bank do not directly work to increase spending, the impacts are seriously muted. Indeed, the main channel is very weak. One has to argue that asset purchases will lower bond yields, which will increase credit growth, which then results in more economic spending and activity. The weak link in this chain is the credit system. Governments are highly focused on increasing macro-prudential regulation, including capital ratios, to make sure that a failure of one big bank does not lead to a systematic collapse of the system. This is a laudable objective. We just want to note that with higher capital ratios and improved risk management systems, the result it that future credit growth has very little relationship, if any, to the size of the central bank’s balance sheet. What matters most is confidence in the future, and absent confidence, a discernible source of new spending – such as an expansionary fiscal policy, which is not going to happen given the debt overhang. So, our perspective is that unless a central bank buys private sector risky debt or equity that can clearly produce more corporate spending and capital investment, QE based only on sovereign debt purchases will not generate higher levels of real GDP.
The effectiveness of the ECB’s QE program might also be limited by its regional nature. Rather than the ECB buying government bonds and other assets directly, it will instead give its member central banks funds with which to buy their own countries’ bonds. This mechanism, a compromise of sorts designed to assuage German opposition to QE, will limit the exposure of each country to another country’s debt. In some ways this is darkly reminiscent of the disjointed, regional approach that the US Federal Reserve took to battling the Great Depression after the untimely death of Benjamin Strong , the influential governor of the New York Fed, in 1929, although we don’t expect a Europe-wide repeat of the 1930s turmoil in the event that the ECB’s QE proves ineffective.
There is a signaling effect, however, that may help. The ECB’s move to embrace QE contrasts strongly with the US Fed’s exit from QE and current debate on raising short-term interest rates. Consequently, to the extent that the QE signal from the ECB leads to more euro depreciation against the US dollar, with a lag, this could push consumer prices higher and help exports.
Putting it all together, here are our conclusions:
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the authors and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.
Bluford “Blu” Putnam has served as Managing Director and Chief Economist of CME Group since May 2011. With more than 35 years of experience in the financial services industry and concentrations in central banking, investment research, and portfolio management, Blu serves as CME Group’s spokesperson on global economic conditions.
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