The ECB easing decision could lead to a major break with Germans on policy
The ECB did the expected this morning and lowered interest rates enough to send bank deposit rates at the ECB into negative territory. The ECB also met market expectations with an additional easing measure by implementing an LTRO with lending to household and business strings attached. Though these actions were expected, they are unprecedented, and, for that reason, dramatic.
I believe the ECB shied away from a discussed securitization program because of German opposition to easing. Nonetheless, Draghi said more is coming. And the Germans are up in arms across the political spectrum. We could be on the cusp of a major political break as a result. Some thoughts follow below.
What led to negative rates and LTRO?
This whole train of events has been a long time coming – seven months to be specific. Before I get into what to expect, let’s look at how we got here – and remember the German – Periphery dichotomy.
Back in November, I wrote that the ECB rate cut highlighted dichotomies within Euroland, and that Italy was the country to watch in the context. Here you had boom times in Germany but ongoing depression in Portugal, Italy, Greece, and Spain. A 25 basis point cut in the context of austerity and internal-devaluation-driven deflation in the periphery seemed rather minor to me. I wrote then that “given the ECB’s inability to finance the spending of its member sovereign states, the ECB is almost out of ammunition. In my view, this makes downside risk from deflation and debt-deflation higher than it is in the U.S.”
Italy was begging for more (as were other periphery countries). But in the German press, the question was about the effect of low rates on savings and investment in the euro zone. The German Bundesbank had already warned of overheated housing markets. I wondered aloud whether low rates were skewing private portfolio preferences.
Now, by November, outside forces were already putting political pressure on the ECB to get aggressive. For example, the OECD recommended unconventional policy in November.
In that context, the FT was reporting that a north-south was developing. But the story behind intrigue at the ECB was that the statements by Austrian and German central bankers made clear that there was no north-south divide at the ECB. Rather, there were differing views about how aggressive the ECB needs to be to prevent deflation from becoming a problem. And all of the period leading up until now has been about trying to allow the data to drive consensus for further action. Poor data – especially on the inflation side – would mean an aggressive response. And the data were poor, hence today’s action.
By December, therefore, the ECB was considering the LTRO scheme it has now implemented among other policy options. The last six months have been about watching the data and getting more and more people onside for taking action if and when it was necessary.
The German problem
The problem with doing anything unconventional is the Germans. Yesterday I highlighted the negative German reaction to potential unconventional measures at the ECB using commentary on Tuesday by former ECB Chief Economist Juergen Stark as an example of how opposed many in Germany were to aggressive action. Stark sees no deflation and believes none of the measures now being taken will have any positive effect on lending and business conditions in the periphery. Moreover, he sees the attempt to revive specific sectors of the economy as beyond the ECB’s mandate.
Today, we could see the same thinking throughout the German press and across the political spectrum, echoing Stark’s views entirely. The Wall Street Journal Deutschland has a good overview of the commentary that I will translate below (link in German here) and the FT has more that I will also add.
Here are some sample reactions from within Germany:
- CDU/CSU Vice Chair Ralph Brinkhaus: “The key to overcoming the economic crisis is a policy of enduring structural reform and not one of low interest rates… The ECB must ensure that it does not overstep the bounds of its Mandate… If Mr Draghi is attempting to conduct selective economic policy for only parts of the euro area, then this is without question not his role.”
- Green Party fraction finance expert Gerhard Schick: “The ECB can not overcome the economic plight of Europe. It is therefore always questionable if they try anyway and thereby even accelerate up a significant gear.”
- FDP board member Volker Wissing: “The decision of the European Central Bank is an alarm signal. [The central bank confirms with their decision] that, in contrast to the grand coalition, it considers the euro crisis far from overcome… Against this background, the irresponsible spending of Union and SPD takes on a new dimension.”
- IFO President Hans-Werner Sinn: “This is a desperate attempt to redirect capital flows to southern Europe with even cheaper money and penalty interest on deposits and thereby stimulate the economy there. The bill will now be paid by all those who invest money in the long term — the savers and the owners of life insurance policies.”
- German Institute for Economic Research head Marcel Fratzscher: “The rate cut and the negative deposit rates are more symbolic measures than anything.”
- German Association of Private Banks: “A negative interest rate on the deposits of commercial banks at the European Central Bank is unlikely to lead to the desired pick-up in lending and the interbank market…In addition, we hardly see the currently much-discussed threat of deflation.”
- German Association of Cooperative Banks: “Through the ECB’s decision the already low interest rates for safe savings products will fall further. This weakens the incentives to save for Germans and puts the efficiency of private pension plans in danger.”
- German Association of Public Banks: “By cementing the interest rate level today the ECB has increased this risk aversion and thereby contradicted their own intention to accelerate the availability of credit.”
- German Association of Savings Banks: “Instead of the hoped for boost to the economies of the crisis-hit countries, savers across Europe will be further alienated and asset values will be destroyed through the new interest rate cuts”
This is a full and blanket condemnation of the ECB’s rate decision from all sectors of the German economic and political elite. The best thing that was said is that the measures are symbolic and likely to be ineffective.
With this level of vociferous opposition to the ECB’s monetary policy within Germany, we should ask ourselves whether ECB easing could lead to a major break within the eurozone on monetary policy. I think it could.
As for the effectiveness of the decisions, I am sceptical. First, the reduction in interest rates is indeed merely symbolic. It will have no impact on investment and lending decisions.
Second, the negative deposit rate is just a tax on banks. It will not boost lending. Rather, it will simply reduce bank capital accumulation at a time when euro banks are trying to increase capital in order to meet Basel III requirements. This, in and of itself, should reduce lending. Moreover, neither Denmark nor Sweden have had any positive experience with negative deposit rates. What the Danish negative rate experience tells us is that a deposit rate cut will drain liquidity from the euro area as banks look to get rid of their excess reserves.
Only the LTRO scheme has any chance of working. Even here, I am sceptical because banks are repaying the LTRO funds, causing the ECB balance sheet to shrink. Why would a new LTRO with strings attached be an incentive for lending, particularly to those riskier segments of the economy like households and small and medium-sized business without any implicit backstops from government? At least larger business can get bailouts and thus protect banks from default. But SMEs and households will default if the economy turns down. Should we expect banks to now lend to them because of a subsidized lending program? And if they do, would that be a good thing or something that ends in defaults down the line anyway?
The ECB has been forced into this course of action by circumstance. The policy stance in Europe of backloaded austerity and internal devaluation is deflationary by design. With fiscal authorities’ hands tied, monetary policy is the only game in town. And the ECB’s mandate compels them to act. Because the ECB wants to prevent a debt deflation, it has been forced to act pre-emptively, with prices falling near deflationary levels eurozone-wide.
Expect more of this from the ECB too. Draghi was quoted by the Wall Street Journal as saying “Are we finished? The answer is no. If need be, within our mandate, we aren’t finished here”. That says more is coming. And if we get more, the reaction from the Germans will be even more negative. Moreover, I don’t think these programs will be particularly effective. Europe will remain mired in a slow growth paradigm for months and years to come, negative deposit rate, LTRO, QE, or not. The problems in Europe are not about high interest rates. The principal problems are private sector indebtedness, low bank sector capital levels, and poor institutional architecture. The ECB will fix none of this.