The Eurozone’s QE Problem

Over the last couple of weeks, as the Federal Reserve ended their latest round of quantitative easing, there have been many calls that the pickup of the "QE Baton" by the BOJ and ECB. The problem is that the impact of liquidity interventions in Japan and the Eurozone do not carry the same "punch" as was witnessed in the U.S due to differences in economic underpinnings. Furthermore, while Japan can easily implement QE since they are a sovereign currency issuer, the ECB is not and must rely on the generosity of its members.

As I wrote this past Monday, Japan has officially slipped into a third economic recession in as many years despite the BOJ's efforts to stimulate a return of economic prosperity and inflation. This is not a new problem, as Japan has been fighting disinflationary pressures in their country for the last 30 years as shown in the chart below. Japan's internal struggle with an aging population, lack of savings and accelerating debt/GDP ratios continue to plague economic prosperity.

Much like Japan, the Eurozone has also become entangled in same "liquidity trap" as member countries continue to avoid making necessary structural reforms to cure their burdensome debt, dependency and unemployment ratios. As shown, the decline rate in economic growth since 2007 shows the real problem. Despite successive rounds of monetary interventions and suppression of interest rates by the ECB, the Eurozone has only experienced fits and starts of declining economic activity.

The ECB's Problem

As I wrote previously in "The Eurozone Could Be A Problem For Stocks:"

"The following chart of wages, labor costs, and price inflation clearly shows the increasing problems facing the Eurozone economies."

"The negative feedback loop to the Eurozone economies from declining wages and overall deflationary pressures has nullified attempts by the European Central Bank to spark some inflation across economies. While there is continued 'hope' that the ECB will launch further successive rounds of monetary interventions, there is clearly a diminishing rate of return of each dollar spent."

That point was confirmed in a recent article by Ambrose Evans-Pritchard of the Telegraph which stated:

"The European Central Bank’s plans for €1 trillion of monetary stimulus is fraught with risk and is likely to fail without full-blown bond purchases, Standard & Poor’s has warned.

 

The agency said the ECB’s blitz of ultra-cheap loans to banks (TLTROs) cannot generate more than €40bn of net stimulus once old loans are repaid, given regulatory curbs imposed on lenders.

 

Jean-Michel Six, the agency’s chief European economist, said ‘doves’ on the ECB’s governing council know that the loan plan is unworkable but are going through the motions in order to persuade German-led ‘hawks’ that all conventional measures have been exhausted, even if this means a debilitating delay.

 

'Risks of a triple-dip recession have increased,' said Mr Six. "The ECB has one last arrow and that is quantitative easing of €1 trillion, needed to restore the M3 money supply to trend growth."

However, the major problem for additional rounds of QE by the ECB is that the bulk of the funding for additional QE falls on the shoulders of Germany. Jens Weidmann, the head of Bundesbank, continues to push back against further stimulus efforts due to the liability imposed upon the German taxpayer.

"It is unclear whether the OMT case will in fact clear the air. Euroceptic groups and professors in Germany are already planning to file a fresh case against QE at the German Constitutional Court if the purchases escalate, arguing that the scale entails large liabilities for the German taxpayer and circumvents the budgetary sovereignty of the Bundestag.

 

They argue that QE is fiscal policy by stealth, conducted outside democratic control. Some experts say such a case would give the Bundesbank the legal excuse it wants to step aside from any ECB bond purchases, effectively rendering the ECB action null and void."

Furthermore, Klaas Knot, a Dutch central banker and governing member of the ECB council, recently noted but he doesn't see a reason to pursue further QE currently.

"We're not categorically ruling it out, but I'm skeptical if it would be effective."

His reasoning is that many Eurozone governments currently borrow at historically low rates and therefore he suggests that there is "no reason" for the ECB to buy their debt.

These comments have all come following ECB President Mario Draghi comments that fueled speculative investor hopes of additional QE that have pushed markets higher. 

While S&P states that the ECB must launch "radical stimulus" to head off a "deep deflationary slump" regardless of Germany's political and economic views. Again, the problem that remains for the ECB is that nothing can be done until the European Court has ruled on a former case involving its bank-stop plan for Italian and Spanish debt (OMT). Until that ruling is made, the ECB is caught in a log jam with only Mario Draghi's promises of action keeping hopes alive. Chief Economist Peter Praet has insisted that the ECB is not bluffing stating:

“We say we are confident, we are going to get the volume and, if it is not sufficient, we are ready to take additional measures and broaden the base of purchases immediately."

Markets will surely now hold him to this sweeping pledge, however, promises alone will only keep that markets complacent for a while. As Mr. Six said:

"QE is a necessary condition for recovery in Europe, but is not sufficient in itself. The question is where does this bridge take us? The eurozone can survive a couple more years of miserable growth, but it can’t go on forever like this before people lose hope. There is political risk almost everywhere."

The Feedback Loop

As I have discussed previously, the U.S. economy is very much at risk of what is happening in the Eurozone and Japan. With domestic financial markets hitting all-time highs, it certainly seems as if the U.S. can stand alone, however, that is likely not the case.

 Sy Harding recently wrote an interesting piece entitled "The Eurozone Is A Growing Problem For U.S. Economy?" in which he cited three very crucial points relating to the issue of sustainability:

• The 18-nation euro-zone is the largest economy in the world, eclipsing that of the U.S.
• The euro-zone is the largest trading partner of the U.S.(The largest importer of U.S. goods, the largest exporter of goods to the U.S.)
• The euro-zone is in an economic crisis.

The chart of EuroArea GDP above clearly illustrates the importance of Sy's points as the economic conditions in the Eurozone are getting "worse" rather than "better." The size and importance of the Eurozone on the domestic economy should not be underestimated as exports comprise roughly 40% of domestic corporate profits. As noted in the NYT, by David Jolly:

"The performance in the Eurozone bodes poorly for the already shaky global economic outlook."

As an investor, you do have to at least ask yourself if the current surge in the domeitic financial markets is justified given the still anemic economic recovery. While it certainly seems that "nothing can wrong," we have seen such complacency before when bullish sentiment was "off the charts." It is important to remember that it did not end well.