What is the definition of insanity? Doing the same thing over and over and expecting a different result. That according to this definition the president of the European Central Bank (ECB), Mario Draghi, is insane, has been demonstrated yet again. The Italian central banker embarked in March 2015 upon a large-scale asset purchase program, which is better known as “quantitative easing.” Today, almost twenty months have passed and we are in a position to safely evaluate the results of Mario Draghi´s decision. And that is exactly what we will do in this article. The decision to extend the purchase program to the end of December next year is unjustified. The ECB president committed himself to an insane decision and is gradually turning the market into a permanent manic-depressive state.
To Taper or Not to Taper
The ECB asset purchase program began in 2015 with a monthly amount of €60 billion euros. After a few months, this amount was increased to €80 billion euros. In other words, the ECB creates every month €80 billion in new money, withdraws €80 billion worth of bonds from the bond market, and saddles commercial banks with another €80 billion in bank reserves.
The announcement of the ECB to extend the asset purchase program, went hand in hand with the decision to lower the amount of monthly purchases to €60 billion euro. “Tapering,” the market responded. And “tapering” implies a restriction of (cheap) credit.
But Mario Draghi was quick to reassure the market by making some additional remarks about the board´s decision. Even though the monthly amount will be reduced from €80 to €60 billion, how could the market possibly come to the conclusion that the ECB was “tapering?” In the end, Mario Draghi just extended his QE program which was about to expire in March next year? And did Draghi not decide that he would lend government bonds to banks with bank reserves as collateral?
Remember, government bonds are often used as collateral in repurchase agreements (repo´s), clearing (of futures contracts, for instance), and in other types of transactions. With the ECB gobbling up a great share of all outstanding government debt, there was a shortage of collateral: prices of these kinds of “collateral” (that is, government bonds) was going up. Well, guess what. Draghi will lend out some of bonds (but only a total worth of €50 billion) in exchange for bank reserves, charging a predatory interest rate.
“Bankers are crooks,” we often hear. Fortunately, people with some accumulated anger against bankers, while ignoring the roles played by central bankers and regulators, are able to content themselves ever since QE began. The most important result of QE so far, as well as the most important result of QE in the future, is a tax on banks.
Banks earn money on the margin between, on the one side, the interest they pay to finance their liability column and, on the other side, the interest they earn from their asset column.
Part of the asset column of banks consists of bank reserves. That is, a bank account at the ECB. The interest rate on this bank account is, however, negative.
How does QE essentially work? The ECB buys bonds from banks and pays … by adding the purchase amount to the banks´ ECB bank accounts.
The only way out for banks is to lend more (as a result, bank reserves as a percentage of assets would decrease), until they have no more bank reserves than is legally required by the ECB. But banks are not able to lend more, because – simultaneously with ECB policy – financial regulation from Brussels and its surrounding areas is increasingly taking its toll. For a clear example, one only has to look at the Basel II and III agreements. With these new regulations, commercial banks are forced to comply with certain liquidity requirements (which refers to the amount of bank reserves a bank must hold) and capital requirements.
Even if banks would be able to find creditworthy borrowers in droves (something which in the current economic conditions and with today´s existing debt burden is not quite simple), then still it is difficult to “lend more” because of fresh out of the oven bank regulations.
And that the ECB, on their turn, adds another €80 billion of negatively yielding ECB bank deposits, does not quite help. Banks find themselves between a rock and a hard place. The negative interest rate on ECB deposits is, far from being an effective monetary policy, a direct tax on commercial banks.
On top of that, banks have difficulties to pass on negative interest rates on to their average depositors, since they simply withdraw paper currency.
Evaluating ECB´s QE
The QE asset purchase program of Mario Draghi has, except that i timplies a tax on commercial banks, achieved nothing. The purchase program has various goals, among which:
- Increase inflation (Mario has an unexplainable fear for price deflation)
- Stimulate banks to lend more
The underlying inflation in the Eurozone has not picked up (except for the crude oil effect, something Edin Mujagic explains crystal clear in his articles) and total bank credit is still on the same level as before QE began. In short, we most definitely cannot speak about a resounding success.
Even the famous but wrong “wealth effect,” where people feel “richer” because stock prices are high and they therefore begin to spend more, is not defendable under Draghi´s policy. European stock prices, after all, have not increased since the European QE asset purchase program.
The only thing that Draghi did achieve, and will now worsen, is:
- Keeping bank profits under pressure;
- Inflate the prices of some bonds (both government as a select club of corporate bonds).
Despite the fact that many people remain outraged over what banks did back in 2008, Draghi´s policy is counterproductive. By imposing a de facto tax on banks, it makes it increasingly difficult to increase bank capital. At the same time, new regulations demand that banks increase their capital. An impossible situation. Current ECB policy breeds financial instability, because banks that do not comply to the newly imposed capital requirements are “insolvent” from the point of view of the regulator, which is a rationale to intervene in the bank´s structure through a “bail-in.”
That I am not making this up myself, is demonstrated by the stock prices of European banks. Bank shares fallen over 24% since the beginning of Draghi´s QE. There goes the idea that the former Goldman Sachs banker is making his buddies immensely rich.
At the same time, the absurd policy of Draghi has led to near zero or even negative interest rates on government bonds and some corporate bonds (namely, the bonds that Draghi decides to buy). More demand leads, after all, to higher prices (and in the case of bonds, prices are inverse to interest rates, that is, more demand leads to lower interest rates).
Yields on German, Dutch and other Eurozone country debt went down to historical lows. Corporate bonds followed suit, especially when the ECB began buying them directly: Volkswagen, Deutsche Bahn, Telefonica, they are all part of a privileged club.
Yet Mario Draghi, through his interventions, is turning the market into a manic-depressive maniac. Only the idea that the ECB will “taper”, that is, reduce the amount of monthly purchases from €80 to €60 billion euros, has resulted in a staggering increase in yields on 10-year German bonds, to highlight a specific example.
And that will be the beginning of the end: the bond market is addicted to the heroin needle of Mario Draghi. The sooner the victim receives no more drugs, the less severe the withdrawal symptoms.