ECB: Europe Can't Bend

Tomorrow we learn of the participation of the second opportunity to borrow funds from the ECB under the Targeted Long-Term Repo facility.  Recall that this year's access was limited to 7% of a bank's loan book (loans to households and businesses excluding mortgages).  Next year's access is somewhat linked to growth of that loan book. 

The aggregate size of the eurozone banks' loan book implied they could borrow as much as 400 bln euros this year.  At the first opportunity, banks borrowed 82.6 bln euros.  This was very disappointing, but there were some mitigating factors, like the pending results of the Asset Quality Review and the stress tests. 

Tomorrow's takedown is expected to be larger.  Banks are expected to draw down about half of the 317 bln euros that they have the potential to borrow.   The less the participation, the stronger will be the calls for the ECB to engage in a sovereign bond purchase program to make good its intention to expand its balance sheet by roughly one trillion euros. 

The risk is on the downside.  Rather than duplicate the success of the Long-Term Repo, which were widely used, the TLTRO appears, in practice to be a subsidized loan facility to mostly peripheral banks.  Core banks are unlikely to be significant participants.  There is no generalized need for additional liquidity, especially given the ECB's 20 bp tax on excess liquidity parked with it.  There are other sources of cheap funding available.  Banks can borrow as much as they want (have collateral for) from the ECB with its full allotment of repos at 5 bp. 

Even if the participation is greater than anticipated, it is still difficult to see how the ECB's balance sheet can expand by so much based on current efforts.  Consider that the covered bond and asset-backed securities purchases have totaled a little less than 22 bln euros.  Already there have been reports warning that the ECB's modest purchases of covered bonds is crowding out the private sector. 

Moreover, between now and February banks will have to repay about 270 bln euros of the LTRO borrowings.  This return of funds to the ECB is the primary reason the ECB's balance sheet has shrunk.  Some the LTRO funds may simply be rolled into the TLTRO or folded into other liquidity facilities that ECB offers. 

The most likely reason why a sovereign bond purchase program has not been implemented by the ECB is because the support for it is not sufficient.  Draghi indicated that a unanimous decision is not needed.  Indeed, many important decisions by ECB have not been unanimous.  These include Trichet's bond buying scheme (SMP), the OMT (which the Bundesbank has testified against), the TLTROs, and the more recent upgrading of the language about the expansion of the balance sheet to an "intent" from an "expectation."

Many observers think that Germany has some sort of veto over ECB policies.  It may, but it is not so obvious.  Reports do indicate that Draghi has reached out to Berlin for support.  However, Weidmann is not as isolated as many observers  have suggested.  Germany's Lautenschlaeger, who is on the ECB's Executive Board, also reportedly objected to the changing language regarding the balance sheet growth and is opposed to a sovereign bond purchase program.  

A majority of euro zone countries are debtors.  They are more inclined to support a sovereign bond buying program.  However, the ECB's Executive Board is more divided, and it is not clear that Draghi commands a significant majority.  

Leaving aside the legal issues about fiscal transfers, there are practical reasons why Draghi has failed to convince a majority of creditors that it should engage a sovereign bond buying program.  First consider efficacy.  The ostensible goal is to boost inflation and inflation expectations by expanding the ECB's balance sheet.    It is not clear that sovereign bond buying achieves this.   Countries that have rapidly expanded their balance sheets, including China, Japan, Switzerland, the UK and US may have enjoyed initial success, but it has largely fizzled out.  

The ECB's Chief Economist and member of the executive board Praet suggested that in other times, it might be best for policy makers to look past the fall in oil prices.  He said the ECB might not be able to afford that luxury.  In a similar vein, Draghi had suggested after the recent ECB meeting that it is not so much that sovereign bonds purchases are somehow illegal, rather it is illegal not to achieve its mandate. 

It may sound reasonable, but it is wrong.  The ECB's mandate is price stability.  It chose for itself how to define this.  It chose to look at headline inflation.  No one told it that it could not focus on core inflation, like many other central banks, including the Federal Reserve.  

Back in 2008, with oil prices rising above $140 a barrel, the ECB hiked interest rates, just as the eurozone fell into a prolonged contraction from which many countries have yet to emerge (which is a fairer understanding than some sort of triple recession that some observers talk about).  Now Draghi and his allies want to repeat the mistake from the opposite direction. 

Keynes talked about being restricted by paper shackles, contracts.  But the main ECB shackle is not paper but ego.   Core inflation in the euro area stands at 0.7%.  It is low but not emergency low.   Oil prices are experiencing one of their biggest declines in fifty years.    In 2008, as oil prices were rising, the Federal Reserve looked through it and was cutting interest rates.  Fed leadership is encouraging the same thing now.  Indeed, as the ECB debates with itself about easing policy in part due to the ostensible deflationary impulse generated by the drop in oil prices, the Federal Reserve is likely to modify its forward guidance next week, scrapping or diluting its reference to a "considerable period" before raising interest rates. 

Once past the TLTRO, the market's attention will turn to next ECB meeting on January 22.   There will be much speculation that a sovereign bond purchase program will be announced.  However,  Greece's PM Samaras' early  start to the presidential selection process may mean that by the ECB meeting, it will be in the run up to a national election (assuming a super-majority does not support the government's presidential candidate in three tries by the end of this year).  The anti-austerity Syriza is ahead in the polls.  It would seem an awkward time to announce a sovereign bond buying program when the potential next prime minister of Greece is on the record calling for official sector haircuts on Greek bonds. 

If the timing of the first ECB meeting in 2015 is problematic, the venue of the second meeting is not conducive.  The next meeting is March 5, and it will be held in Cyprus (though due to the new rotating voting scheme, Cyprus will not vote at that meeting).   To announce a sovereign bond buying program in Cyprus rather than Frankfurt does not make for good public relations. 

If the eurozone economy is a ship with two engines (monetary and fiscal policy), and one is off-line (fiscal policy), making the other one (monetary policy) work harder does not get one to the destination quicker.  Rather if the starboard engine is not working, stoking the port engine makes one go in a circle.  Perhaps a couple of years ago, a sovereign bond buying program may have worked and been effective.    The main problem of the euro-area is not monetary policy.  It is not that interest rates are too high or that there is insufficient liquidity.  The financial fragmentation has lessened.  Yes, peripheral borrowers pay more than core borrowers.  In other times, this would be recognized as appropriately pricing risk; desirable behavior.  

The ECB has repeatedly tried to fill the vacuum created by austerity and the lack of structural reforms.   It cannot create aggregate demand.  It cannot boost potential growth.   ECB officials recognize that monetary policy is just one part of the policy response.  Monetary policy has worked, but it is no closer to overcoming its governance or coordination challenges with fiscal policy and structural reforms.   Moreover, nearly every eurozone country faces a rising anti-EU political force, which also limits room to maneuver.