Tag Archives: ECB

New Cracks in the Euro

News today suggests that the central European economies are beginning to surge ahead with growth while at the same time the periphery continues to struggle terribly.

In today’s US print edition of the Wall Street Journal there is news that German GDP in December continues to grow. We only just read that house prices are surging too. As Germany starts to surge ahead, it will need to push interest rates up to help control growth and prevent overheating.  

See German Economy Accelerated Last Year and Eurozone Output Data Suggests Strong Upturn.  
But Greece, Spain, and even Italy, really don’t want and may not even be able to sustain an increase in interest rates. The Greek economy has not yet recovered. It needs persistent low rates and in fact additional help (or changes in policy) to help repair the damage.

As such the pressure-cooker-politics of the Euro is about to get a dose of heat. It won’t be another six months before the pressure becomes clear to all.
 

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Open Letter to Mario Draghi: Wake Up!

December 6, 2016 

Sir,

I am in receipt of a copy of the transcript of your recent a speech, “The Productivity Challenge for Europe”. I have to report that your paper makes little sense and completely avoids the negative impact that your policies, as head of the ECB, have had in holding the EU’s economy back.

But before I identify the errors in your analysis I need to first highlight how your initial assumptions, outlined in the first part of the speech, are presented backwards. Here are several of your assumptions:

  • “Stronger potential output growth aids monetary policy by increasing the equilibrium real interest rate.”

Sir, this is self evident. However it is the interest rate policy of the ECB that has stifled risk and investment that can drive growth. It is not growth that aids policy; it is policy that should be creating opportunity for growth.  
Now the second backward facing assumption:

  • “And higher future growth helps monetary policy today. It encourages households to spend more and firms to invest, reducing the need for monetary policy to support current economic activity and bring inflation back towards 2%, and speeding up the return to more conventional monetary policy settings.”

This is similar to the first item; it is not growth that affords a monetary policy; it is monetary policy that should be assuring growth. You are clearly looking at the real world backwards. This will again become clear as we look and analyze your prescription to the problem of lack of growth.

The main body of your speech calls out correctly the cause of the stagnant euro productivity figure. You correctly call out capital investment and efficient allocation of resources (to the more productive) as the challenges facing us today. And supporting both of these is, ultimately, the diffusion of innovation across the region and non-frontier firms (I too read the OECD paper).

However sir, I see a weakness in your monetary policy. Firms are not sitting on their hands with a bunch of ‘shovel-ready-strategies’ waiting for the right interest rate level before launching one. Firms have strategies, first and foremost, independent of interest rate. Some of those strategies require funding and at that time, the firms’ treasurer or CFO will compare the range of funding options available.

You see sir, you have only to ask company treasurers and CFOs how they use interest rates to realize that perpetually low or even negative interest rates are anathema to growth. They are killing our economy.

As to resource allocation, well, since the capital markets are massively distorted is it any wonder that internal company allocation methods are screwed up too? With quantitative easing and the vast sums of money sloshing around the community, it turns out that companies were and are able to alter short-term ‘strategies’ to leverage it all. They simply launched non-natural M&A (at an all time high) and stock buy-backs that meet EPS targets more easily than riskier long term capital investments.

You do touch on several other polices that would positively impact rates of diffusion of innovation, namely:

  • Fostering more competition 
  • Well functioning capital, product and labor markets 

Alas the very polices you and your kind seek and set are preventing the realization of these polices:

  1. There is reduced competition due to excessive regulation and tax policies that favor established and larger firms over smaller and new
  2. Capital markets are being massively distorted as explained above
  3. Product markets are held hostage to, again, red tape and too much government involvement
  4. Labor markets are held back due to the same nanny-state efforts

Sir, I implore you to look at the data in front of you. Meet with twenty CFOs. Get out a little bit and talk to real people and put your books of theory away. I beseech you- before you bring the whole edifice of the EU down.

I have the pleasure of being, sir, your obedient servant.

A. White

Brexit: Mainly the Right Decision for Mostly the Wrong Reasons?

The title of this blog captures how I would summarize Brexit, the U.K. Referendum to leave the European Union. After watching the story unfold intently from afar, the visiting and immersing myself in local dialog over the last three weeks, the tittle of this blog captures the essence of the situation.

The reality is much worse, again for the wrong reasons. Let’s first look at the decision.

  • Technically the process and the method by which the UK will leave the EU has not even started and won’t until October.
  • How the divorce will shape up will be subject to protracted negotiation. Clause 50 has never been tested. Also the UK is a large economy, with several advantages, namely its own currency and exchange rate (to buffer any risks) and the city of London financial center.
  • There are numerous related dominoes that make scenario planning more useful than predicting one single outcome. This includes the foolish attempt by the leader of the SNP who wants to turn Brexit, a UK referendum, into something about Scotland.  

Now let’s look at the pre-Brexit political, or should I say marketing, spin:

  • Neither those for Remain or Leave debated honestly. They could not even agree common terms of reference; how much money the UK gave to the EU versus how much was given back in terms of subsidies, could not be agreed. 
  • There was significant scaremongering from the Remain campaign, led by the generally liberal or progressive establishment, supported by economic groups including the IMF. Yet a minority of smart investors who have continually beaten the pundits like the IMF identified great opportunity for the UK. One wonders if much of the ‘economic advice’ was more political than practical. No act by the EU to penalize the UK would be countenanced long since a) it penalizes both sides, and b) the very arguments used by the EU for open, friendly, collaboration would be exposed for what they really are- unelected dictatorial bureaucrats.
  • The Leave campaign led their supporters in the belief that immigration would stop with a vote for Brexit, as if humanitarian aid were an EU and not a national or moral concern.  There are significant immigration challenges for all countries; remaining or leaving the EU is not central to the real issue.  

The bottom line is therefore the Brexit vote was more an emotional vote, and nor a rational vote.

Finally let’s look at the post-Brexit situation on the ground. In no particular order:

  • The leader of the Scottish National Party wants to reposition the UK referendum as if it was a Scottish referendum. Since the majority of scots voted ‘remain’, and since the UK voted ‘leave’, surely it means Scotland is being forced against its wishes? Utter rubbish. London also voted to ‘remain’- does London cede from the Union?
  • The Prime Minister, David Cameron, is to step down. This is a great shame as he is a good negotiator and politician. He has fallen in his own sword, a rare political act these days. By comparison, the socialist leader of the Labour Party, equally culpable in losing the ‘remain’ vote, has no idea where his sword is. I am not so sure he has one. But 24 hours later he is being stalked by his own resigning front and back benchers.
  • The pound has taken a beating. This was to be expected. It will recover soon, though it may take time. The recovery against the euro will be dependent on the stability of the euro, not the fragility of the U.K. economy. Spanish and other elections in the next 12-24 months will sort this out.
  • U.K. stocks took a beating but already they are recovering, whereas continental markets are suffering more pressure. This is a leading indicator of sentiment that will again show up in currency values in the next year or so. 

And to top it all off you have to understand the irony of Brexit. In the 1960s France vetoed the UK (twice!) and prevented it from joining the Common Market. And this was only 20 odd years after the close collaboration during the Second World War. De Gaulle felt that the UK’s demands for joining would weaken France’s position, and they would have. The result was that aspects of the Common Market and EEC developed without direct UK input and one could argue therefore that the groundwork of the EU was therefore weakened, and the UK never felt central to the initiative.  This was to haunt the experiment as Britain never really forgave France this veto.

More recently dissatisfaction with ever closer European integration was rejected. Initially countries would vote “no” and reject the the EU Constitution changes. Then those same countries were pressured to re-vote in order to get a “yes”. Finally the Dutch and French rejected the Constitution and it was killed off. However the EU continued. Fifty years after De Gaulle’s unfortunately selfish veto hobbled Europe, it is the UK that triggers what could be the straw that breaks the EU. Fair play, and what irony.

The divorce won’t be clean. There will be much acrimony and hard, complex negotiation. The City of London will be diminished initially, until the cracks in euro fracture and break open.  The U.K. economy will reflect increased short-term uncertainty across the global economy, yet will bounce back towards more positive UK growth within a year. Again, as the euro struggles, so the pound will benefit.  

But in truth no one wins with Brexit. The U.K. will suffer more short term; europe, the EU and euro zone in the longer term.  Everyone will be poorer for Brexit. The reality is that we need a rethink for how Europe wants to live and work together. An unelected bureaucracy is not the answer. We need a new model. The real valuable question is not what happens to the EU now; the visionary question should be “who will document, discuss and lead the ideal EU II framework?”   Let’s demand our moribund politicians work for us and work for a future, not argue over the trappings of an idea that died years ago.

The Peculiar Thing about Currencies and Bonds

As every day passes by our central banks and currency czars head further and further into uncharted territory. What is going on now could not have been predicted, and the resulting behavior cannot be anticipated. Worse, there are no lights at the end of the tunnel, just ever growing darkness.
This weekends newspaper headlines highlight the nightmarish situation:

Japan’s nightmare roots are well known, starting with record breaking public sector debt, which continues defy logic but has yet to become an active challenge. This makes Japan different to other sovereign states but the other roots are common across other nations as follows.

The Bank of Japan (BoJ), like many other central banks, has a never-seen-before burgeoning balance sheet as a result of Quantitative Easing (QE), a process whereby central banks purchase debt and therefore drop billions of dollars (or local currency) from the sky. This policy helps lower interest rates and thus, so the theory goes, encourages private sector investment and so economic growth (e.g. GDP). This has not happened. The ghoulish result is that:

  • Firms did not increase capital spending 
  • But instead took out low cost bonds to fund massive and ongoing share buy-backs and unproductive or natural-cycle meters and acquisitions.

The result is that the investor class has gotten richer and inequality has gotten worse. As the data published by central statistical agencies around the world report the depressing news, corrosion in trust by the public in the political system increase now to the point where national elections are being fought more on distrust with government than with positive policy comparison.

QE encourages the exchange markets to disinvest in the local currency, thus lowering the exchange rate. This should then, so the theory goes, encourage exports. However this has not happened either. The monstrous condition now is that other large, mature, trading nations are in the same boat and all are engaged in the same QE effort. So all markets are flooded with cash, and the trillions of dollars that slosh around in the currency exchange have no clear direction where to call home. In fact, as one nation lowers its rates, in the hope encouraging some increased exports, other nations have reacted with additional QE this neutralizing any advantage sought. The result is a rush-to-the-bottom where we continuously lower rates without any resulting benefits. And bottom we are approaching with zero, even negative rates. At some point banks will have to pas such rates onto households.

As the article about Japan reports, the BoJ must be considering new action at some point, but political considerations will likely figure strongly due to the pending US election. More crucially when everyone is in the same sinking boat, one would think that coordination, nay, collaboration might be the order of the day. And when I mean collaboration, I am thinking along the lines of Bretton Woods or Plaza Accord. We cannot get out of these woods, or prevent the boat from taking on more water, with the current beggar-thy-neighbor approach. 

The other side of this nightmare is just as confounding.  

German yields, the return for holding a bond of government debt over a long period of time, is approaching zero. It could well go negative very soon. Japanese yields went negative earlier this year and US yields are very close to zero too. If you take into account (meager) inflation, real US yields are already negative.

Note that the Federal Reserve holds about 20% of outstanding government bonds (i.e. debt); the Bank of England holds about 26% of the U.K. Government gilts (i.e. debt); and the Bank of Japan holds about 30% of their government debt, as of March. The ECB holds about 10% of outstanding German government debt. So the market is hugely distorted, and private buyers are crowded out. 

But the complication does not stop there. In the interests of QE, the ECB is now expanding beyond government debt into corporate bonds, which crowds out even more the private sector. This changes the dynamics for how forms seek long term capital investment. Investors (see WSJ ECB’s Debt Purchases Cause Concern) are now worried that should private bind holders sell any amount of debt, the price will swing violently due to the loss of liquidity as a result from central banks owning large swathes of the market and not being active in it.

The perverse logic of negative rates means that there is no incentive for investing in the debt. More staggeringly we are slowly learning that we can only just guarantee the return of the capital ‘stored’ in those bonds. And the assumption is that the cash when returned the will be worth less than it is now. But as demand increases for this unproductive asset we have to assume that this is the best of a bad bunch of investment options. What does that say about our confidence in waking up and getting out of this situation?

But do our economic and financial leaders work together to find a global solution? No they do not. They seem happy to assume our problems are not at a global level but can be handled one decision, one policy, one central bank at a time. They have signally failed to solve this problem alone and in tandem. They need to work in parallel and that requires real collaboration, the kind not seen since Bretton Woods and the Plaza Accord.  I have been talking about this need for global collaboration for some time – see my last missive, Preserving our Future Wealth for Future Generations, and my earliest from 2015 Open Letter to Christine Laguarde, head of IMF.

This is an inside down financial world and there are literally no signs of getting out of it. The one hope, the one glimmer of an way out, is if inflation does take root. That once enemy incarnate is now needed to save our economy before our leaders ruin it. They show now signs of taking a global leadership role. So we pin our hopes on inflation. And by the way, if inflation ever did take hold, that won’t be pretty either. Remember the central bank’s balance sheet and amount of QE ‘out there’ in the market? That would have to be sucked out pronto and yields would alike immediately and rates would raise dramatically. We are set for a nightmare that will just go on, and go on.

The Euro Currency Sham – Exposed by ECB Chair, Mario Draghi

I was perusing an article in today’s US print edition of the Financial Times titled, ‘ECB alarned at UK push to rebrand union‘.  Mario Draghi, president of the European Central Bank, is quoted as he comments ondesigns  by David Cameron, UK’s prime minister, to rebrand the euro a ‘multicurrency union’.  The facts are that 19 of 28 European countries use the euro.  Britain and Denmark have an opt-out clause and have free floating currencies, and other 7 countries peg their currency to the euro.  Cameron’s plan is to change wording (the multicurrency part) and ensure, with treaty changes, that Britain and any one else can keep their own currency if they want too – and won’t be pressured, or lose out to other advantages unique to the euro zone.  

The FT article suggests: “Mr Dradhi shares concerns in Brussels that the EU single market could permanently devide around two regulatory spheres, with eurozone countries facing unafair competition if there was a lighter-touch regime on the outside”.  Eurozone countries facing unfiar competition?  What is he talking about?  Surely the premise of the single currency is predicated on some advantage?  How can being part of a single currency suddenly be something that loses out to a region that is not part of that currency?  Is Draghi admiting that to have ones’ own currency is an advantage?  What silliness is this?

The fact is that all currency pegs and currency alignments have given way.  Not one has lasted, from the early beginning of monetary union to recent times.  The euro is certainly lasting a long time, but it is under extreme strain.  The same interest rate policies, set to meet the needs of the euro’s largest paymaster, Germany, created bubbles in Greece and Spain that have since exploded, and are creating new bubbles in Ireland now – which was only bailed out by the ECB and IMF just a short time ago.  Ireland’s GDP is running rampant – and cannot be taimed since they cannot alter their interest rates.  

Draghi has done us all a favor – he states what he fears the most.  A single currency removes the ability for a country to buttress its own inherent wage ‘stickiness’ (its inflexibility to change, i.e. drop, when competitiveness drops) against the needs of a flexible interest rate to manage currency exchange.  When the UK was booted out of the ERM, the last time it was party to the euro’s predicessor, it’s economy went from malaise to growth in rapid time.  This happens time and again through history.  Thank you Mario for telling us your greatest fear.  I guess keeping the euro keeps you in a nice, cushy job.

ECB and US Fed – Into Uncharted Waters

As the US Federal Reserve contemplates increasing interest rates for the first time since 2006, the ECB is working on a plan on taking its interest rate deeper into negative territory.  In both cases the tools being used are not conventional, the practice is new and based on theory, and the outcomes are predicted, not known due to past experience.  If ever there was a definition of uncharted monetary waters, this is it.  And what a time to be gambling.

To be fair the US Federal Reserve does not set interest rates directly.  Before the crisis the Federal Reserve managed two levers that effectively drove interest rates.  First it mandated and managed the reserve limits banks should maintain with the Fed as “cover” for their loans to help pretoct against runs on the bank.  Any additional money above this minimum was deemed “excess reserves” and would attract interest.  At the same time the Fed offered a rate for short term borrowing to banks; this was used periodically by banks when their own funds were short, or if there was a short term imbalance between banks.  This “inter bank rate” was used in what became known as the federal funds market, and the rate fluctuated based on demand – as supply was unlimited with the Fed being the printer of money.  

Since the crisis however the Federal Reserve balance sheet has ballooned through the QE program.  Its balance sheet has gone from $900 billion in 2006 to $4.5 trillion today.  See Journal of Economic Perspectives, Rewriting Montary Policy 101: What’s the Fed’s Preferred Post-Crisis Approach to Raising Interest Rates, Ihrig, Meade and Weinbach, 2015.  The reserve requirements on what banks need to maintain have grown substantially since the crisis, and so the clearing point for supply and demand has moved significantly but the Fed does not plan sell those assets that comprise part of the challenge.  It plans, according to the paper, to start increasing interest rates on the excess reserve balances with the Fed.  This should encourage, so the theory goes, banks to use their excess reserves in more risk taking adventures such as loans to business – that is assuming businesses are looking for loans (which they are not).  

As the excess reserve rate rises the difference with the public rate will increase and through arbitrage, the gap will or should close.  What this means is that you could borrow money at one rate and re-use (re-loan) it at another, and make a profit.  To reduce this, the public or market interest rate will follow quite closely the interest rate on excess reserves.  No one knows if this will work – it’s never been done before.
At the same time the ECB is talking of more QE and further increasing their negative interest rates.  In this case, as reported in today’s US print edition of the Wall Stree Journal (see Divergent Paths Set for Fed and ECB), they are hoping that such negative interest rates will not be passed onto the high street and more public uses of interest rates.  So far, the negative interest rates used by the ECB, and other countrieslike  Denmark and Switzerland, have not been passed on to consumers.  If they were to be, then citizens would be penalized for saving.  And of course saving is one key enabler for the natural recycling of  money to investments.  Again, as with the US experiment, no one knows if this will happen since the ECB is making it up as they go along.

The problem is not the rates: the problem is with money.  The huge amount of money sloshing around in the system overall has distorted how businesses operate.  We just dont know what will happen in the next phase of the cycle.  In saving the global economy we have created a new monster we dont know how tame.  Isn’t it fun to be an economist at this time?

The Missing Link in our Economic Recovery – Productivity

In Friday’s US print edition of the Financial Times there is an article called, ‘Eurozone needs to look beyond monetary policy‘. If you had missed it Mario Draghi, the ECB president, has signaled in the last day or so that the ECB is open to increased quantitative easing (QE) and possibly lower interest rates. This is an attempt to redress the balance between a slowing economy in China and a US Fed that delayed raising rates. In other words it is beggar-thy-neighbor process in a race to the bottom. And Mr. Draghi is thinking the euro needs a new round to help improve Europe’s position.
The article suggests that while QE and (negative) interest rates are valid monetary polices to work with, there are two others that really have not been focused on by either the European or the US authorities. They are targeted infrastructure expenditure and productivity. The IMF have suggested the former quite forcefully and have reported that even some increased public debt might be worth the investment. But the policies and actions related to productivity are not being promoted by governments and so are not reported in the news at all.  

Productivity, and specifically IT driven productivity, has not been growing as well as it has in the past, nor as fast as it needs to in order to throw off the kind of growth our economy needs to mask the issues surrounding the politics of redistribution and the growing debt challenges. With good growth we can cope with all manner of issues that our politicians are unable to solve. Yet with meager productivity improvements, the economy is left stagnant and we find ourselves in the situation we are in now.  

From my work in the IT industry I can see that individual body of the firm is alive and well and seeking its own individual improvement through whatever means at its disposal. But as a whole, the soul of the firm is tired after years of regulatory and political onslaught. We need change if we are to help the whole economy rather than leave it to individual firms to thrive in spite of our systems.

There are a range of policies that could be enacted that would help drive productivity and so help grow the economy from a demand side of the equations. These range from the political (less likely to be agreed) to the financial (some chance, at least):

Educational reforms:

  • Eliminate the expectation that university is for all – it never was meant to be
  • Increased support for international visa’s to allow those that graduate to stay and find jobs in America
  • Increased vocation collaboration at the local level – not mandated at the federal level (since collaboration has to take place on the ground and is dictated to by which firms operate where, not by lobbyists in Washington)
  • More productivity based metrics and motivations for teachers, not to reduce standards to get more “passes” but reduced red tape to allow teachers to try their own methods and monitor/reward the successes and replace those that fail (the Unions need to get out of the way of progress)

Tax reform

  • increased tax credit for all forms of R&D investment including capital investment
  • A tax holiday (2 years?) to allow firms to repatriate foreign cash reserves when used to R&D investment only
  • Increased tax write off for education and training programs
  • Increased tax credits for industry and university collaboration
  • Reduced red tape, regulation and tax rules for start up and small firm operations in the first 3 years of operation

Targeted spending

  • Fund state level allocation of federal funds for well publicized infrastructure projects. They need to be public to ensure politicians don’t “pick their favorite winners” and they should be accountable for the selections
  • Increased public school investment where results are improving. Reduced funding for public schools where results fall, after a probationary period. Devolve this task to state level but monitor at federal level for oversight only

These are just a few ideas. I realize these are not directly related to IT, but they are directly related to how firms operate and behave, and IT plays a key role in how such behavior change is supported. IT has its own role to play – but the garden has to be fed and watered. And right now, IT is really only being exploited by individual firms. We need to create an environment that will unleash the creative, invisible hand of the entrepreneur. Such an innovator, in this current age of digital business, will create new and fast growing firms and industries. I think we can all agree that would be a good thing.