Wednesday, November 26, 2014

The Big Easing

BRUSSELS – More than three years after the financial crisis that erupted in 2008, who is doing more to bring about economic recovery, Europe or the United States? The US Federal Reserve has completed two rounds of so-called “quantitative easing,” whereas the European Central Bank has fired two shots from its big gun, the so-called long-term refinancing operation (LTRO), providing more than €1 trillion ($1.3 trillion) in low-cost financing to eurozone banks for three years.

For some time, it was argued that the Fed had done more to stimulate the economy, because, using 2007 as the benchmark, it had expanded its balance sheet proportionally more than the ECB had done. But the ECB has now caught up. Its balance sheet amounts to roughly €2.8 trillion, or close to 30% of eurozone GDP, compared to the Fed’s balance sheet of roughly 20% of US GDP.

But there is a qualitative difference between the two that is more important than balance-sheet size: the Fed buys almost exclusively risk-free assets (like US government bonds), whereas the ECB has bought (much smaller quantities of) risky assets, for which the market was drying up. Moreover, the Fed lends very little to banks, whereas the ECB has lent massive amounts to weak banks (which could not obtain funding from the market). In short, quantitative easing is not the same thing as credit easing.

The theory behind quantitative easing is that the central bank can lower long-term interest rates if it buys large amounts of longer-term government bonds with the deposits that it receives from banks. By contrast, the ECB’s credit easing is motivated by a practical concern: banks from some parts of the eurozone – namely, from the distressed countries on its periphery – have been effectively cut off from the inter-bank market.

A simple way to evaluate the difference between the approaches of the world’s two biggest central banks is to evaluate the risks that they are taking on.

When the Fed buys US government bonds, it does not incur any credit risk, but it is assuming interest-rate risk. The Fed acts like a typical bank engaging in what is called “maturity transformation”: it uses short-term deposits to finance the acquisition of long-term securities. With short-term deposit rates close to zero and long-term rates at around 2% the Fed is earning a nice “carry,” equal to about 2% per year on bond purchases totaling roughly $1.5 trillion over the course of its quantitative easing, or about $30 billion.

Any commercial bank contemplating a similar operation would have to take into account the risk that its cost of funds increases above the 2% yield that it earns on its assets. The Fed can determine its own cost of funds, because it can determine short-term interest rates. But the fact that it would inflict losses on itself by increasing rates is likely to reduce its room for maneuver. Its recent announcement that it will keep interests low for an extended period thus might have been motivated by more than concern about a sluggish recovery.

By contrast, the ECB does not assume any maturity risk with its LTRO, because it has explicitly stated that it will charge banks the average of the interest rates that will materialize over the next three years. It does, however, take on credit risk, because is lending to banks that cannot obtain funding anywhere else.

The large increase in the ECB’s balance sheet has led to concern that its LTRO might be stoking inflation. But this is not the case: the ECB has not expanded its net lending to the eurozone banking system, because the deposits that it receives from banks (about €1 trillion) are almost as large as the amounts that it lends (€1.15 trillion). This implies that there is no inflationary danger, because the ECB is not creating any substantial new purchasing power for the banking system as a whole.

The banks that are parking their money at the ECB (receiving only 0.25% interest) are clearly not the same ones that are taking out three-year loans at 1%. The deposits come largely from northern European banks (mainly German and Dutch), and LTRO loans go largely to banks in southern Europe (mainly Italy and Spain). In other words, the ECB has become the central counterparty to a banking system that is de facto segmented along national lines.

The real problem for the ECB is that it is not properly insured against the credit risk that it is taking on. The 0.75% spread between deposit and lending rates (yielding €7.5 billion per year) does not provide much of a cushion against the losses that are looming in Greece, where the ECB has €130 billion at stake.

The ECB had to act when the eurozone’s financial system was close to collapse at the end of last year. But its room for maneuver is even more restricted than that of the Fed. Its balance sheet is now saddled with huge credit risks over which it has very little control. It can only hope that politicians deliver the adjustments in southern Europe that would allow the LTRO’s recipient banks to survive.

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    1. CommentedThomas Lesinski

      The best insurance against this risk would be for the ECB to provide enough monetary stimulus that economic and credit conditions across the eurozone improve enough to prop up asset markets, restore full employment, and increase the tax base that serves as the basis for sovereign debt repayment, so as to calm the general fear. Go explain them that.

    2. CommentedProcyon Mukherjee

      The Fed over-drive in QE 1 & 2 (and who knows may be 3 in the making) has a risk profile that is more than what has been portrayed in the buying of the relatively risk-free U.S. government bonds or Treasury bonds (the other name of printing dollars). By keeping the marginal interest rates near zero the financial intermediaries and commercial banks with the investment banks leading the pack have amassed huge balances that has not gone in investments into the economy but in bartering of financial products that have helped to create a price run that is resembling a bubble. While wage and prices in the general economy have troughed, the stocks and bonds by virtue of trade have been on a run for the crest.

      The European Central bank on the other hand is dealing with the credit worthiness of banks in the Southern countries to whom no one would lend and thus taking on the risk of soverign defaults for the longer term as these banks invariably move the funds to buy its government bonds. By increasing the moral hazard of these banks, ECB is drawing itself into another crisis.

      Procyon Mukherjee

    3. CommentedDahai Chong

      So if those deposits flow out of ECB when possible, when economic outlook is better, will there be danger of inflation?

    4. CommentedDahai Chong

      Some analysts said that reason why US treasury bond is more stable than eurozone sovereign debt despite a higher debt ratio and deficit ratio is that: balance sheet of US corporate and household is better repaired than those of eurozone, and extent of deleveraging process of the US is deeper than eurozone.

    5. CommentedMATTHEW M

      The German banks took their southern indulgent children to the county fair many times over the last decade. They filled them up on cotton candy, hot dogs, and ice cream. All items lacking in any nutritional value (think debt incurred for solid investment say in infrastructure, emerging technologies.)

      And this was good for Germany: its banks lent to Southern EU partners who in turn bought lots of German goods.

      Now, that the kids are saddled with sick birthday party stomach, there is no laxative or Mylanta forthcoming from Germany.

      Instead, austerity ie starvation is preached as the panacea. From bloated over eating sore tummies to empty ones that ache with austerity pain. Killing growth and any ability to pay down debt for generations.

      The German dominance over Europe who knew would have been orchestrated through the tentacles of modern finance. Hitler must be smiling in his grave.

      The southern countries are going to soon realize they have only one option. Default and leave the EU.

      And the sooner the better. The entire world refuses to participate in orderly debt de leveraging. Therefore, bring on the chaos.

    6. CommentedJonathan Lam

      gamesmith94134: The big Easing

      Daniel Gomes,

      You masy not beliwve your eye, if you know one from IMF and one from Brussel can do in printing money.

      Gamesmith94134: Golden Rules for the Eurozone

      After reading the issue on regulating European insurers, I was dumbfounded for the attitude for which how Brussels see solvency works with the currency exchange. I apologize in resurfacing the old records that are relevant to the issue on the golden rules and insurers. I lost my appetite to write for days after the fall of 3% China Stock and DJ.

      Regulating European insurers---from Economists
      From Brussels, with shove
      “Solvency 2” will transform not just insurance but capital markets, too

      Just before we can see the foundation of the currencies exchanges rate in Libor and ECB’s large-scale long-term refinancing operation (LTRO) has been that Italian banks are once again buying Italian government bonds, and Spanish banks are buying Spanish bonds with its lower rates. But, we must realistically decide the two speeds economies in the EU system will not be integrated even Brussels cannot control or agree on many issues. Consequently, we must talk of the reality of growth that is not coming in the next years. It is not liquidity of Bank or solvency of the debts, but the basis of exchange and balance of trade is due to a correction.

      I only hope writer remember the consequences of the Lloyd of Landon (97) and AIG (2008), just before he suggested his golden rules for Euro Zone, and he may regret it; if his golden rules would ever polarize the developed nations and emerging market nations with more argument of the currency exchange rate or bagger thy neighbors could be eminent for the coming WTO meetings. Personally, I think EU or Euros will not last if its financial system is not complying with fairer trade on the foundation of good will.

      May the Buddha bless you?

      Gamesmith94134: Striking Euro Gold (and Silver) 11032011

      “Milton Friedman’s bimetallic standard inherently more stable than a monometallic (gold-based) regime.”

      When you recieve two bids of Euros, in from Germany and the other from Greece; you would take the bid from Germany over Greece. Would you discount the euros of Greece with 15% just for sake of the confidence vote? Why should you discriminate one over the other as in Euros? It was the deficiency of credit that Greece may bear or the contagion as you may believe. If it is the investment consisted of US dollar and Euro in the open market trading, you would have no choice on the bids. Reluctently, you may have to accept the higher bid, even though you realized that you are under the attack by a raider or hedge fund manager. Suddenly, you may lost your company with the lesser of 51% of the control of it. It is how hedge fund managers or raiders use monetarism to undermine the weaker ones with weak currencies even for sovereignty nations; since the open market system does not provide a gatekeeper to stop the manipulation. Since the investments from aboard may not create growth or productivity if there is not sufficient time to grow in completion of the business cycle or create productivity on the invested with no innovation or products. It is merely exchange of hands for such transaction. It is how the sovereignty debts are created under the influence of the activity of hedging with the cost of living rises; and loss of credit as the pooling of its fund weakens. Therefore, it is advisable to revive the bimetallic standard to create the gatekeeper on the handicaps of the domestic currencies and international currencies; whenever investments are made by the foreign communities or sovereignty debts.

      If the bussiness transaction happens in a community only like London, people buy, people sell within a single circuitry of currency that share the same standard of credits, commodities and culture; such transaction do not affect the value of the its currency or increase on productivity. If a foreign investment is involved; the circuitry expands or contracts for its excesses or shortages in the pooling of its currencies, or commodities. Subsequently, it would create a shortfall or surge in value of the exchange that is not a bottomline to the business cycle or productivity.

      When there is a 3% interest credit charge on the market, I would gain 2% with my 1% interest credit charge even I have my US dollars exchanged to British Pounds, since there is no handicaps on the exchange. It is why many complain on the fiat money and the liquidity traps when the foreign investments are often being manipulated the currency rate changes for a stronger currency to weaken its own that caused inflation of the weaker currency; or withdrew at great mass that cause the shortage of cashflow or credit.

      In term of redistribution of wealth, the middle class of earnings did not match the growth after inflation; because the investment was dislocated while business cycle was not completed; or the productivity was not sufficient for a pay raise in matching the profit growth. Perhaps, we can blame on the competitions, but there is no comparison if there is no foreign investment or import of goods; and if it were a enclosed environment that no export is made. But, if we are taking advanage of the foreign investment or imported goods or resources to create productivities, sovereignty nations must restore the soveignty currencies to safeguard its citizenry from the invasion of currencies or resources that creates hardship for its people and allot resources for the exchange of goods and services from the foreigners. Then, the citizen must not pay for what the banker did; and stop telling me to pay tax my million dollar house that I did not earn. Parhaps, the line is drawn that the politicians must realize they must pay their bills too; instead of raisng our tax for their mishaps.

      As we learn from the recent soveriegnty debt crisis an financial disaster, we are clear at principle of the fiscal and monetary system must sustain both of balance and growth. Free Trade must free of mainpulation of the resources or invasion of others by using currencies or political powers; and each sovereignty nations are entitled to feed its people with domestic currency and trade it goods with the common currency availbale to obtain a better bargain for imported or exported. In addition, I prefer Zones in continents in protection of the weaker sovereignty nations with its neighbors nations to fend off the unwelcomed transaction that would be considered as hostile; because some investments are not solely privatized as it claimed; and free trade must be invited and not broken in or out at free will. If we all play the same rule, the world would be better for the citizens and governments too.

      May the Buddha bless you?

    7. CommentedDaniel Gomes

      Are these articles even screened before published?

      The author is so misinformed and biased that is sickening.

      For starters, according to different publications such as the Financial Times, most of the banks which bid for cheap money from the ECB were German banks!
      More than half according to reports, including bizarre entities like the Financing branch of Volkswagen!

      So not only the ECB was giving cheap money to German banks for them to buy German bonds but was also subsidizing German industry and exports!

      Furthermore, despite all the spins by arrogant German authors like this one, it was not the peripheral banks which got cut off from the credit markets due to their irresponsible behavior in the first place!

      Peripheral countries' banks did not over leverage themselves like so many of the German banks! Quite the opposite!

      Has everyone forgot of Commerzbank / Hyppo/ regional German banks over-leveraging?

      Has everyone forgot of that the ECB went immediately to the rescue of these bankrupt banks with their overnight cash facilities and most important by taking all kinds of junk toxic assets as collateral from this banks?

      It is also a known fact that Germany was after the UK the country which required more assistance to its corrupt banking sector!

      In 2008 the ECB even took toxic assets used as collateral from these people meaning that all countries in the euro are taking a very big potential loss of their ECB capital just because we ALL HAS TO HELP GERMAN BANKS and to a lesser extent , Belgium, Netherlands like Dexia and ABN AMRO etc

      Nevertheless the profits this banks reaped off during the run to this crisis have been taxed in their home countries like Germany!!

      Quite interesting that now Germany and Netherlands are the virgin prostitutes of financial discipline!

      On the other hand the banks from peripheral countries did not over leverage themselves multiple times! Quite the opposite!

      They only got cut off from the markets because their host countries got cut off from the markets because due to the irresponsibility of the Anglo-saxon, German, Netherlands banking sector, the credit confidence collapsed in Europe!

      It's absolutely unbelievable that Germany made the ECB the lender of last resort (with loads of free/cheap money) to German bankrupt banks twice and now refuses to allow the ECB from lending to periphery countries even at reasonable rates!

      So after Europe had socialised German banks losses in 2008, now in 2011/12 we had to help them offload the Greek bonds they happily purchased for the pas decade thus removing the link between risk and profit and sending Greek bonds rates into an endless upwards spiral and pushing Greece into the abyss! But thank God we saved German banks! the same time they prevent the ECB from lending one dime at reasonable rates to any periphery country!

      What is this??

      And still, like this author, they behave like virgin prostitutes carrying a burden!

      So Europeans must foot the losses of German financial sector from their own irresponsibility so that they can subsequently buy German bonds in order for the fuhrer to recycle that into loans (at loan shark rates) to peripheral countries which did not cause the crisis in the first place ???

      Why not take the money offered by the ECB to Volkswagen and lend it to Peripheral countries at the same rates while the so called markets refuse to lend to peripheral countries?
      Could it be that Germany is simply interested in prolonging the crisis to its own benefit? I sure think so.

      Finally in case the author needs a lesson in economy, lending money at 1% when inflation is way higher and when the market rate is also way way higher is nothing short of giving money, most of which finds its way into Germany.

      Is there any honest humble German left who can produce an analysis of the nett inflow (ECB cash from 2008 to 2012) and outflow of money (EFSF) in reference to Germany???

      Germans are once again building on superiority myths .. i wonder where will this end up!