FYI | Mar 30 2009
By Greg Peel
“The world stands at a watershed. We cannot afford crises like this every 10 years. We need a global order for the financial markets, the likes of which we’ve never seen, in order to learn the lessons from this disaster,” declared German Chancellor Angela Merkel in Berlin over the weekend.
Merkel’s comments, while made in front of her own national congress, were aimed squarely at G20 leaders and specifically the host of Thursday’s G20 meeting, UK prime minister Gordon Brown. Brown has been campaigning ahead of the London meeting to drum up solid support for his policy of spending whatever public money it takes to right the global economic ship. In a way he is simply trying to justify the actions of his own government, which has been first mover on bank nationalisation and quantitative easing in the face of a collapsing UK economy, however given the US has moved to similar measures, he may have thought support was easily garnered.
But he was wrong. While many in Europe have been outspoken against plunging the public purse further and further into debt, including European Union president (on rotation) and now ousted Czech prime minister Mirek Topolanek, it is the protestations of the EU’s two largest member economies which carry the most weight. Both Germany’s Merkel and French president Nicolas Sarkozy have stated their objection to Brown’s platform of public injection at all costs, preferring to push expedient changes to world financial regulation to the fore.
As Merkel has suggested, the world does not really want a GFC every ten years. The argument is that the GFC began because of excessive global debt, and Gordon Brown’s policy is one of simply replacing private debt with public debt – a move which only sweeps the problem under the rug for another day. Fix the markets now, says Merkel, through regulation – not through hand-outs to the offenders.
The contrasting view from Brown, and from US president Barrack Obama and his Treasury secretary Timothy Geithner, is that further disaster must first be prevented before regulatory changes can be decided upon down the track. If this means effectively giving public money to the private offenders, then so be it for now. Some of the offenders have been deemed “too big to fail”.
The moral question is: Is the US, for example, simply trying to head off another Great Depression or trying to maintain a way of life built on excessive debt in the first place, and thus global superiority?
It has all now become a bit academic, at least as far as this week’s G20 meeting is concerned. Recognising the dangers, from public perception, of walking away from the meeting as leaders who could not agree over the greatest world crisis since the 1930s, The G20 has now back-pedalled over what was intended to be discussed in the first place. The summit found an unlikely spokesman on this matter in the form of Australian prime minister Kevin Rudd.
“That was never the intention,” Rudd said on the weekend, referring to Gordon Brown’s hopes to walk away with a G20-coordinated specific economic stimulus plan. “A mechanism has been established for us to reflect on for what we need for the future. There will be a further summit, well in time for 2010 I assume, which will actually look at what metrics, what numbers, will be needed then.”
Even Downing Street responded with doubt that another G20 could be held before 2010. But if the G20 was to achieve nothing more than to set up a task force to look into further coordinated public spending, and another to report back on proposed changes to financial regulation, we should not be surprised. G20 meetings are merely symbolic. The real action goes on behind the scenes.
But the world cannot otherwise wait until 2010 to make a decision on anything. Angela Merkel might favour regulation over public spending but recent EU data show a collapse in European industrial production much greater than economists were already pessimistically predicting. Economists at Standard Chartered expect the European economy to continue slumping in the second quarter ’09, and for EU GDP to contract on average by 3.4% in 2009. While degrees vary, the US, UK, Japan and Europe are all now looking at significant recession.
And that poses a problem for the European Central Bank. The ECB is not charged with managing European economic growth – its only mandate is to protect the euro against inflation or, as the case may be, deflation. Given a slumping economy has now led to rapid disinflation in Europe, deflation is a very real threat. While an inflationary spiral is a dangerous beast, a deflationary spiral is even harder to break out of. Just ask Japan.
Standard Chartered expects European inflation to turn negative in June.
It took the ECB a while to emulate its US and UK central banking counterparts in slashing rates as the GFC unfolded. Indeed, the ECB originally raised its cash rate in the face of rising inflation, when commodity prices were out of hand, quite surprising the world. But at that point the world also thought the credit crunch was mostly an American thing, and that the European economy would come out relatively unscathed. No one thinks that anymore.
The ECB has since lowered its cash rate to 1.5%, which compares to the UK’s 0.5%, Japan’s 0.1% and America’s zero to 0.25% range. While this might suggest that the ECB believes Europe is still in a better position than its peers, realistically ECB monetary stimulus has actually been more extensive than 1.5% implies.
It is no surprise that the ECB should have adopted measures different to other central banks. Other central banks have one economy to look after, the ECB has 27. And many of them are strange bedfellows.
Standard Chartered notes that while the cash (or “refi”) rate in the EU is now 1.5%, the ECB has otherwise been providing European banks with as much liquidity as they demand. This policy of “enhanced credit support” means that realistically the overnight rate in Europe is currently 0.98%. But the benchmark for market rates has become the ECB’s deposit rate – interest paid on the funds European banks deposit with the central bank – and that is 0.5%. So in essence, the ECB’s monetary policy rate is already as low as the UK’s which, incidentally, is the lowest in the 300-year history of the Bank of England.
One reason why the ECB has adopted a policy rather different from, say, the US Federal Reserve is because traditionally European companies favour bank loans over corporate bond issuance. Some 70% of all company borrowings are from a bank. The Americans, however, favour the more modern form of debt financing in which companies go directly to the market for funds. The Fed has cut its rate to zero in an attempt to encourage corporate credit.
The result is that while the official ECB rate is 1.5% and the Fed rate is zero, European interbank rates at 6-12 month maturity are actually lower than their US equivalents and mortgage rates are somewhat lower as well.
This may be well and good but as the adage suggests, “you can lead a horse to water but you can’t make it drink”. The Fed may have cut its cash rate to zero to provide bank access to cheap funding, but mostly that funding has gone no further. US banks have been focused on the necessary policy of protecting balance sheets rather than the risky business of lending money to corporates in a GFC. Hence the Fed and the US government have undertaken all sorts of other direct measures in which the central bank’s balance sheet is expanded to include everything from corporate paper to consumer loans.
Similarly, the ECB’s “enhanced credit support” has not prevented a sharp slowdown in money growth (the money supply grows as funds are lent out) and in February flows to the corporate sector turned negative. Lending to households has remained broadly flat, Standard Chartered reports. Credit spreads on what European corporate paper is on issue are close to record highs.
So in other words, the ECB is not out of the woods. Its policy measures to date have not yet put a net under shrinking credit growth, and that means deflation is around the corner.
The US and UK (and Japan and Sweden) have all moved to quantitative easing as their latest means of monetary stimulus. This simply means a central bank buying its own government’s bonds with what one might call “funny money”. It’s a highly inflationary practice but Gordon Brown’s argument, supported by others, is that while deflation remains a threat central banks can reflate as much as they like. As much as is necessary. It’s all part of “whatever it takes”.
The EU has no bond, and the ECB is not allowed to finance individual European governments by buying their bonds, so direct quantitative easing is not an option. However, ECB can still adopt other “unconventional” measures such as buying the bonds of different countries in the secondary market (allowed), which is actually how the Bank of England is buying UK bonds, or by buying corporate paper directly just as the Fed, BoE and others are doing.
Such a route still throws up all sorts of EU-specific problems, given moving directly into individual member government and corporate paper means not only does the ECB undermine its independence (individual government approval is required) but it risks fracturing an already disparate collection of economies if certain countries miss out.
Then there is the wider problem of quantitative easing, pertaining to all central banks who have adopted such measures.
Assuming that global reflation policies actually work – meaning they provide just enough counter inflation to the deflation of falling credit demand and falling prices – then at some point the global economy will get back on its feet. At that point, rapidly spiralling inflation can quickly become the next risk. While it is easy to reverse simple liquidity injections by moving cash rates back up again, unwinding corporate and government bond purchases is a more complex problem. That is why many are concerned that quantitative easing is a potential step to hyperinflation.
Returning to Europe again, there is another implication flowing from what a central bank does and doesn’t do, and that is in regard to foreign exchange rates.
When the Fed first started cutting its cash rate dramatically in 2007, the US dollar fell out of bed as interest rate differentials widened. A weak dollar exacerbated the surge in global commodity prices, which in turn led to central banks such as the Reserve Bank of Australia madly putting rates up. But when the world realised that no one was immune from the GFC, other currencies fell out of bed and the US dollar rallied back up on a relative basis.
The yen, on the other hand, also surged because the world was unwinding the risk-based carry trade. An appreciating yen become a disaster for Japan’s export-dependent economy. Similarly, the euro has taken over as the currency of strength in recent weeks following quantitative easing from the US, UK and Japan. Germany is still the world’s biggest exporter, and clearly a strong euro is only impacting further on an already weakening European economy.
On this basis alone, the ECB is forced to consider at least some form of of further monetary policy inflation to bring the euro back into line. Standard Chartered expects that on Thursday the ECB will cut its refi rate from 1.5% to 1.0% and its deposit rate from 0.5% to 0.25%. But other “unconventional” measures will still be needed such that Europe is not left out in the cold.
Such currency problems lend weight to Chinese calls (now echoed by Russia) for the world to move to a reserve currency made up of a basket of major currencies rather than just the US dollar. But no one is silly enough to expect such a move could be made overnight, nor that the US would readily capitulate.
Whatever happens, this week’s G20 meeting will no doubt be an interesting one but, as per usual, not one in which anything much is decided.
