The dark side of the ECB

Lots of people have been focusing on the recent ECB rate rise, but the ECB’s role in this crisis has really been determined by its other – more opaque and less publicised – role: as lender of last resort. This has got the ECB into a near untenable position. It faces huge exposure to peripheral eurozone countries, it aims to maintain price stability, but has also acted to stabilise the whole eurozone economy, and it has underwritten a bloated and inefficient banking sector with unlimited cheap money.

The ECB has lent massively to the struggling European banking sector. Although this may have been viable and necessary to halt the systemic risk from the financial crisis it is now out of control. It has propped up banks that should have gone bust and created banks addicted to ECB funding. A mechanism for reining in lending and winding down banks should have been in place from the start. The ECB essentially dug itself a hole without bringing a ladder to get itself out again.

Let’s not forget, these actions also helped fuel the sovereign debt crisis by creating perverse incentives. These banks could take on cheap ECB loans and then invest in high yielding but relatively safe assets (peripheral sovereign bonds at the time), in order to turn quick profit and increase capital. This fuelled the level of government debt and when it became clear just how bad the sovereigns' finances were, markets panicked and the debt crisis hit (but with more debt and more banks involved/exposed than before).

The ECB tried to fix this problem by throwing more liquidity at it (through its bond buying programme). This just increased its exposure to risky economies, distorted bond markets and rightly raised questions over its independence and impartiality (not to mention being potentially inflationary).

Lastly, the ECB has overseen the build up of huge imbalances in the eurosystem of central banks. Some, like Ireland or Greece, borrow huge amounts but contribute little. The loans to these countries are underwritten by other central banks in the system, making them even more exposed to a peripheral default.

The ECB has played a huge role in the cycling of debt around the eurozone, and put itself in a very exposed and compromising position. Its interest rate policy is massively important but the darker side of ECB policy has debatably played a more important (and negative) role in this crisis.

To be fair to the ECB this was not all of its own making, since it was forced into this situation by eurozone leaders inaction, which is further illustration of the politicisation of a once proudly independent central bank.

A Portuguese bail-out won't be enough

Over on Europe’s World we have a post on the future of Portugal. We argue that a bailout now looks inevitable but that it will do little to solve Portugal’s problems due to:

- Funding requirements topping €39.4bn this year alone, equal to 25% of GDP.
- Unsustainable borrowing costs both in the short term and the long term, as we have already noted.
- Over reliance on ECB funding - both the state and the banking sector
- Massive lack of competitiveness as well as few policy options to facilitate economic reforms and foster growth

Given the mountain of issues facing Portugal, a bailout might give the appearance of providing help in the short term, but restructuring debt and tackling the problem at its source - high debt to GDP ratio and massive amounts of private debt - will provide a much better long term solution for both the country and the eurozone. However, even so, in the absence of some serious reforms to boost the country's competitiveness, going far beyond those that we're seeing at the moment, Portugal may find itself in this position again before too long.

You can check out the full article here.

The cost of dignity

Yesterday, Portuguese Prime Minister Jose Socrates said:

"[Portugal] would lose its prestige and (its) dignity of being able to present itself to the world as a country that succeeds in solving its problems [if it asks for a bailout]."

Today, Portugal auctioned off €1 billion in 2 year government bonds, but the Portuguese really had to pay this time. The interest rate was 5.99% which, for 2 year borrowing, is an exorbitantly high cost. Keep in mind that even with the punitive interest rates of 6% for 3 years, the current bailout loans now look relatively good value for the Portuguese.

Oh, and just in case you thought things looked better down the line: 5 year rates reached 7.82% and 10 year hit 7.70%.

The 10 year rate has been above 7%, the threshold widely accepted as being unsustainable, for 24 consecutive days; Greece and Ireland lasted 13 and 15 days respectively before asking for a bailout. The real question now is not if Portugal needs a bailout but when, and will it be enough? Surely a restructuring would do more for its long term economic stability at this point.

In any case it looks like prestige and dignity are going to hit the pockets of Portuguese taxpayers hard until a decision is made.

Start with the man in the mirror

In an opinion piece in the FT published the other day, Klaus Regling (see photo), the chief executive of the eurozone's temporary bailout fund attempts to counter critics of the common currency.

The unelected official, who looks after €440 billion in loan guarantees, argues that "EMU’s critics will eat their words again", explaining how the euro will be saved through more budget discipline and sounder economic policies in member states.

He gives the example of Latvia, writing:

Latvia which has a currency pegged to the euro, testifies to the success of this policy. Contrary to commentators who predicted disaster for Latvia early last year unless it gave up its hard peg – in line with advice from the commission – it did not devalue its exchange rate. A real effective devaluation was achieved through severe cuts in nominal income. Today its economy is growing again. Those outside “experts”, who always seem to know what is good for Europe, should take note.

He is right that "internal devaluation" can indeed restore competitiveness, although it's questionable whether politicians in countries such as Greece are willing to follow in Latvia's footsteps on this one. Of course Regling omits to mention that, in the case of Latvia, the country's reduced competitiveness was driven by a bust in the real estate market, in turn partly brought about by Latvia's euro peg.

An article on Global Property Guide makes clear that the damage was inflicted by the EU's pressure for a euro-peg on the Baltic country, which isn't eager to go against EU guidance, given that its EU membership is also a matter of geostrategic security.

From 2004 to 2007, property prices doubled, tripled or even quadrupled, just to fall in December 2008 by a crazy 41% in real terms from a year earlier. The euro peg had first pushed mortgage rates disproportionately low, boosting excessive demand for real estate. The following adjustment through increased rates bankrupted many Latvian citizens who saw the value of their investments drop.

In his defence of the monetary union, Dr Regling doesn't mention any cure to the eurozone's most fundamental problem - its one-size-fits-all interest rate policy - which has a tendency to facilitate booms and busts (though not the only factor ). Even the Celtic Tiger, Europe's champion of competitiveness, was floored by these mechanics, as low interest rates created a real estate boom and bust, poisoning systemic banks and bringing the country to the edge of the abyss (despite the fact they passed the EU's stress tests only last summer).

As the German economy continues to boom, there will soon be calls in Germany for the ECB to jack up interest rates in order to prevent inflation. But this, in turn, will seriously undermine Spanish and Irish efforts to get their economies back on track - and potentially off set many of the hard-fought reforms that the two countries are pushing through at the moment.

No matter how much of taxpayers' money EU leaders will put on the table, as long as there really isn't a European economy, Dr Regling should continue to expect criticism of EMU's flawed construct.

And in terms of lashing out at the "outside experts" who know what's "good for Europe", we suggest Mr. Regling starts with the man in the mirror. As Ambrose noted in yesterday's Telegraph,

Perhaps it is unkind to point out that Dr Regling was the European Commission's director-general of economic affairs from 2001 to 2008, more or less spanning the incubation period of the catastrophe now at hand. To borrow the immortal line from Watergate: what did you know and when did you know it?

Interest Rates 'Will Have to Rise Sixfold in Two Years'
THE DAILY TELEGRAPH: Interest rates will have to rise almost sixfold over the next two years to cope with rising inflation, business leaders have warned.

It will bring financial pain to seven million home owners with floating interest rates who will see a jump of almost £200 on a typical monthly mortgage payment.

Charities have already warned that repossessions are likely to rise next year and the threat of a succession of quick interest rate rises will exacerbate their fears.

The Confederation of British Industry predicts that higher than anticipated rises in the cost of living will push the Bank of England (BoE) to begin increasing interest rates in the spring.

It predicted that the Bank base rate – the interest rate at which the BoE lends to other banks – will rise more than two percentage points by the end of 2012. Mortgage rates are expected to follow closely behind. Read on and comment >>> Myra Butterworth, Personal Finance Correspondent | Monday, December 20, 2010

Interest Rates Set to Rise as Economy Recovers
THE DAILY TELEGRAPH: Interest rates will start to rise sooner than expected after official figures showed the economy growing at its fastest rate for a decade, economists have said.

Growth over the past six months reached 2 per cent, the fastest pace of expansion over two consecutive quarters since 2000, according to the Office for National Statistics.

The economy received a further significant boost when Standard & Poor's, the ratings agency, revised its outlook on Britain from negative to stable and confirmed the country's AAA credit rating[.] >>> Andrew Porter and Philip Aldrick | Tuesday, October 26, 2010

THE DAILY TELEGRAPH: Greece reignites Europe debt woes: Europe's debt woes have returned to the fore after Greek premier George Papandreou threw open the door to fresh elections and vowed to liberate the nation from "slavery and surveillance". >>> Ambrose Evans-Pritchard | Tuesday, October 26, 2010

We have remarkable recessions and depressions these days. They used to last for years. Now, if we listen to the so-called specialists, they last for a mere few months! It seems like only yesterday that the UK economy was in danger of losing its AAA credit-rating. Now, its superb credit-rating is not in any doubt. Hmm! What is going on here? Surely Osborne's economic remedies cannot have kicked in yet. They have barely been announced. Methinks the people are being manipulated; methinks they are trying to pull the wool over our eyes. Hype it up, why don't you? – © Mark

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Going Dutch or going bust

Last week, three associations of Dutch pension funds' issued a quite startling warning to the Dutch Parliament: "If interest rates remain so low" they said "the the entire pensions system will be undermined”, adding that insurers could take a serious hit as well.

Thing is, Dutch pension funds are stuck in a tricky dilemma: they're promising their savers annual returns of 3.75 percent or more, but long term interest rates are substantially lower than that (down to 2.13 percent in Germany).

This has led to a big uproar in the Netherlands, as it emerged that as many as fourteen Dutch pension funds could be forced to backtrack on their obligations - for the first time ever. This, in turn, would result in a 14 percent loss for some 150,000 Dutch pensioners. The Dutch pension system is very much designed around a large number of private pension funds, which traditionally have yielded good returns for Dutch citizens - so the pain would be felt.

The Dutch National Bank, effectively working under the ECB, argued that the pension funds had themselves to blame for the problems. But Albert Roëll of Kas Bank blamed the situation on the continued low interest rates and the cheap money the ECB has distributed to banks, in the wake of the sovereign debt crisis in the eurozone.

The Dutch government has now rejected demands from the pension funds to relax capital standards (which they argue would be one of the few ways to address the problems. Adjusting interes rates could have been another, if the Netherlands hadn't given up its control over interest rate policy) .

So what do we see?

- The Dutch pension system, which is world famous for its large share of private pensions, is coming under strain because of the ECB's low interest rates. These rates are in many ways now intended to serve struggling periphery economies in the eurozone and big banks who did unwise investments in these same economies.

- In turn, Dutch pension funds are forced to take on more risks (holding less capital) in order to cope with these strains. The alternative is to cut returns, meaning less money for the country's pensioners.

- Another example of the problems with a one-size-fits all monetary policy in an area with such diverging economies as the eurozone.

Interest Rates 'May Hit 8pc' in Two Years
THE TELEGRAPH: Interest rates may rise to 8pc within two years to choke off soaring inflation, according to radical new research.

Andrew Lilico, chief economist at the influential Policy Exchange think tank, has warned of an interest rate environment not seen since the 1990s. He said the rise could happen as the recovery beds in and Government measures to stave off a recession lead to an explosion in the money supply. Mr Lilico also warned of a return to "boom and bust", as ballooning inflation threatens to tip the economy back in to recession in 2013 or 2014. >>> Philip Aldrick | Saturday, August 21, 2010

Interest Rates Will Go Up Quicker Than Anyone Expects, Ex-Bank of England Officials Warn
THE TELEGRAPH: Interest rates will have to rise earlier and more sharply than expected to keep inflation under control, two former Bank of England policymakers have warned.

Sir John Gieve, an ex-deputy Governor, and Charles Goodhart, a previous member of the Monetary Policy Committee, are the most senior economists yet to have opposed the current orthodoxy that rates will stay low for a prolonged period. The warning will come as a relief to savers but as a shock to homeowners, many of whom are able to meet their mortgage repayments only because of record low rates of 0.5pc.

Addressing Fathom Financial Consulting’s Monetary Policy Forum, Sir John said: “I am expecting a recovery – when that is strongly established I’d expect rates to start rising faster than the market currently expects. I wouldn’t be at all surprised to see interest rates at 2.5pc a year from now.” >>> Philip Aldrick , Economics Editor | Wednesday, August 04, 2010