International investors need to consider what the announcement last week that the European Central Bank (ECB) was going to start quantitative easing (QE) will mean. The Europeans on the continent are going to join the most notable nations of Japan, the United Kingdom and the United States in the policy of creating more money. By purchasing asset backed securities and Euro-denominated bonds on a massive scale the ECB is hoping for several things to occur.
The announcement came on 4th of September when the ECB headed by Mario Draghi held a press conference. First came the unexpected news that interest rates would be reduced even further. The main refinancing rate was at 0.15%. This was now to be reduced to 0.05%. The marginal lending facility rate (what the Central Bank charges other banks who borrow money) previously at 0.4% would now drop to 0.3%. The deposit facility rate, that is what the ECB pays other banks to leave their money with the Central Bank already in negative territory,went down even further. The old rate of -0.1% was reduced to -0.2%. These rates will take effect today.
The news immediately reduced the value of the Euro against the US dollar. It went below $1.29 USD (United States Dollar) a 14 month low.
The anticipation was that the ECB was preparing to purchase up to 500 billion Euros ($647 billion USD) worth of bonds, to help support a buckling Euro-zone economy. Why the beginning of debt purchasing by the Central Bank? Interest rate reductions alone are not having the desired effect on the economy. Another consideration is that the Central Bank is beginning to run out of bullets when it comes to interest rates alone.
For the first time in the history of the common currency in Europe, quantitative easing will commence in October, with no real end date known at this time. The ECB has taken this step to combat the threat of deflation that has already hit a number of countries in the Euro-zone. Deflation makes the problem of excessive debt on a personal and governmental level worse. Debt actually becomes more expensive over time. With wages and consumer prices in decline debt payments become increasingly difficult to manage.
Throughout the Euro-zone, inflation is projected to be only 0.6% in 2014, 1.1% in 2015 and 1.4% in 2016. The Central Bank openly acknowledges, that the annual 2% goal of inflation is no longer realistic in the next few years, under current monetary policy.
The expected economic recovery in Europe has stalled. The Gross Domestic Product (GDP) projections of the ECB have been reduced. The anticipated rates of 1% in 2014 and 1.7% in 2015 have been decreased to 0.9% and 1.6% respectively. In contrast, the ECB has raised the forecast for 2016 from 1.8% to 1.9%.
Unemployment remains stubbornly high in many countries especially among the young. The European average rate is 11.6% at present. The rate in Spain for example is at 25.1%. Portugal is at 14.3% and Italy 12.6%. Ireland is near 12% and France still above 10%. Youth unemployment is far worse. In Greece it stands at 57.7%. Spain is the next highest at a rate of 54%. In Italy it is 43%. Portugal is at 34.8% and France at 22.5%. The European average is at 22.2%. Germany alone has a low rate with just 7.8%. The general unemployment rate for Germany is 5.1%. Only Austria is lower at 4.7%.
If one considers the loss of talent and the contribution to the national economy and Europe as a whole, by having so many people absent in the labor market, it is really disastrous.
In many countries there is negative loan growth as banks have become increasingly reluctant to loan money to consumers despite record low interest rates. The credit markets in some countries in the Euro-zone have practically frozen up.
The pace of economic restructuring in a number of countries has slowed considerably. This will hamper future projected growth in individual countries. It will also hurt overall growth in the Euro-zone because of issues of trade and the common currency.
The growing crisis in Ukraine and the European response through the EEC (European Economic Community) and NATO (North Atlantic Treaty Organization) will also impact growth in Europe. The rising sanctions and trade restrictions that are being placed on Russia will slow economic expansion in Europe. The Russian response in the rising trade war with Europe, will also deal the economy a blow.
European dependence on Russian oil and more importantly gas imports ,cannot be discounted.
What will quantitative easing bring to Europe? There is no doubt it will bring on a run up in real asset prices, particularly in real estate. Since interest rates in the Euro-zone have declined to the point where saving is no longer credible, individuals and institutions will put more money into the markets. One can predict a rise in the stock markets in many countries in the EEC.
It is plausible if the policy of QE continues, that the inflation rate will rise in many of the nations across Europe. That has been the case in the United States. The CPI (Consumer Price Index) does not include volatile energy and food prices. However, these are the two sectors that impact consumers the most overall. So the inflation rate in the United States is much higher then is officially calculated. There will be a similar pattern in Europe. The aforementioned sectors will be impacted first especially given the souring relations with Russia.
Real growth in Europe will return when increases in productivity returns. Policies of QE does not solve this problem. The overly low inflation has been a product of a strong Euro and high unemployment. A strong Euro allows consumers to import cheaper goods from abroad. These products are often cheaper then domestic ones. It puts a downward pressure on prices as national companies lose market share. This leads to layoffs and in turn forces unemployment higher. These same enterprises cannot raise prices in such an environment and there is little incentive for business expansion. Nationally,this translates into lower economic growth.
Strong and sustainable growth can only arrive when the exceptionally high unemployment rates are reduced. As more people enter the job market the demand curve will move upwards. These will need to be real jobs in the private sector not government created jobs. A depreciating Euro will boost exports as European goods will become cheaper abroad. It also will soon make imports more expensive thus making the domestic market more competitive.
Will QE, the virtual printing of money work for Europe? It has not done so in Japan. It has brought nothing but slow growth in the United States. Only in Britain does it seem to have better results but the full effect is still unknown.
The ECB is initiating asset backed securities (ABS) and a bond purchase program which will increase the size of the ECB balance sheet. There will however, not be a policy of buying sovereign debt at this point in time. At the beginning of 2012 the ECB held assets of 3 trillion Euros (nearly $4 trillion USD). That has declined to 2 trillion Euros at present. It is expected that the ECB will at least repurchase assets of at least 1 trillion Euros (1.29 trillion USD)over the next 2 years.
QE will not help with necessary reforms in labor restrictions,and rules that impede and retard business growth. As bad as the growth in regulations are in the United States they are on the whole, worse in Europe. Tax reforms and shrinking the size of government would be very helpful in bringing a return a growth in a number of countries. Foolish polices of past expenditure, have left quite a few nations in the European Union with practically unmanageable and unsustainable debt.
QE is a policy that is enacted as a fiscal and monetary panacea to poor economic decisions of the past. It cannot on it’s own be the answer to what is wrong in a national economy. It will only mask dislocations and instability in the markets. That is is the short term. In the long term it can be quite economically dangerous, especially if countries continue the policies associated with QE too long.
It is also important to note that Germany the strongest economic country in Europe, was opposed to the new cuts in the interest rates and QE as well. Angela Merkel the leader of Germany and the President of the German Central Bank (Bundesbank) are both in strong opposition. Chancellor Merkel opinion is that pro-growth structural reforms are what Europe needs. The strength of the German economy and the fiscal health of the nation under her stewardship is proof enough in her mind. The German policy of low inflation, reduced unemployment and declining governmental debt in concert with high trade surpluses will lead to growth and prosperity. At least it has worked in Germany. Unfortunately, most of the rest of Europe is unlikely or unable to duplicate the German model.