Thursday, December 8, 2011

The ECB - Caught Between a Rock and a Hard Place

This week's announcement that the European Central Bank (ECB) would not engage in additional quantitative easing came as a surprise to the world's stock markets, causing declines across the board in North America.  Mario Draghi, the new President of the ECB, announced on December 8th, 2011 that the ECB would not engage in further massive purchases of Europe's toxic soup of sovereign debt.  This announcement dashed hopes of a joint Eurozone bailout from both the ECB/IMF, EFSF and other world central banks.

Let's open by taking a quick look at how rapidly the ECB's balance sheet has grown with the recent addition of toxic European sovereign debt:

Let's return to the ECB's announcement.  At the same time as the ECB put the boots to further quantitative easing, they announced that they would help support flagging bank lending and liquidity (i.e. credit) in the euro area by:

1.) Conducting two longer-term refinancing operations with a maturity of 3 years.

2.) Reduce the reserve ratio from 2 percent to 1 percent starting in January 2012.

The ECB also announced a drop in the interest rates on the main refinancing operations within the Eurosystem, the interest rate on the marginal lending facility and the interest rated on the deposit facility by 0.25 percent.

Most interestingly, the ECB stated that it would allow banks to use a wider range of assets as collateral to raise cash from either their local national banks or the ECB.  Asset-backed securities (ABS) can now have a rating of "single A" and be used as collateral.  The assets within these ABS must consist of residential mortgages and loans to small and medium-sized businesses. The ABS cannot include loans that are non-performing or leveraged.  This is a huge reduction in the quality of ABS that can be used as collateral; previously, the ECB required a "triple-A" rating.  The ECB has been forced to lower its standards because Europe's banks are running out of "pretty" assets to trade for liquidity.  In addition to accepting trash for euros, the ECB has lowered the reserve ratio as I noted above; this allows the banks to lend more with less on reserve.

The ECB is desperate to get money flowing through the European economy again.  No one in the banking system trusts anyone, bankers included.  The situation is similar to what the United States experienced in 2008 - 2009.  Banks in the United States had lost trust in each other because they were uncertain about the quality of their competitor's balance sheets and were concerned about loan losses.  Right now, European banks are suffering from the same lending paralysis; they will not lend to each other nor will they lend to households and businesses.  This is largely because of the uncertainty surrounding the future of the euro currency.

This graph from the ECB shows monetary growth over the past 12 years; this tells us at least part of the problem with the freeze in credit:

Note the drop in the growth of M3, in particular, since its peak in 2007.  

Let's step back for a moment and define the terminology used by the great minds at the world's central banks.  M3 is the broadest measure of the supply of money in the European economy; it is generally used by economists to estimate the entire amount of money within a given economy.  The ECB defines M3 as follows: 

1.) M3 includes M1 which includes physical money plus overnight deposits, 

2.) M3 also includes M2 which includes M1 plus deposits with a maturity of up to 2 years plus deposits that are redeemable with a notice up to three months,

3.) M3 also includes money market funds, debt securities up to 2 years and repurchase agreements. 

Money supply is generally linked to inflation or lack of inflation.  As a central bank eases, it triggers an increase in money supply through its purchases of government-issued securities on the world's bond markets.  This pushes the price of the securities up and results in lower interest rates which makes consumers and businesses want to take on additional debt.  As well, because the world operates in a fractional banking system, this increase in the amount of money floating around in the system means that banks have more money to lend.  

Now, back to the ECB graph.  M3 growth ranged between 5 and 9 percent for most of the period of time ranging from the late 1990s until it reached its peak in 2007 when it grew by more than 10 percent.    M3 growth dropped dramatically in 2008 - 2009 and has remained between zero and 3 percent since the later part of 2009.  Part of the problem was that the Eurozone was experiencing rising inflation as shown on this graph:

Inflation is well above the ECB's target rate of 2 percent and is showing no particular signs of dropping.  The ECB tried to control the rise in prices by cutting the supply of money, in fact, in 2009, the overall M3 fell by 0.2 percent and rose by only 1.8 percent in all of 2010 as shown on this chart:

M3 is still growing at a very slow rate in the last half of 2011 with growth rates ranging from 2 percent in July to 3.0 percent in September, falling back to 2.6 percent in October.  This is well below historical norms.

From this data, we can readily see that the ECB is caught between a rock and a hard place.  Inflation in the Eurozone is showing no sign of slowing and remains well above the ECB's comfort zone.  Inflation levels that make central bankers unhappy are present in the system despite the fact that the growth in the supply of money has been severely curtailed, the opposite to what conventional thinking would suggest.  If the ECB boosts the growth supply of money to historical levels, inflation could worsen.  As well, the ECB has been forced to drag Europe's banks to increase their lending, another factor that works against keeping inflation under control.  On top of that, the ECB finds itself accepting far less secure assets in exchange for liquidity.  The ECB now finds itself boosting its rapidly growing balance sheet with less and less attractive assets, including bonds of European nations that are one step away from default and "single A' rated asset backed junk.

Unless Europe's sovereign debt and private banking sector ills correct themselves soon, I would suspect that a collapse of the Eurozone economy is in the cards, similar to what the United States saw in 2008.  With the world's economy being so tightly bound together, we will all be in this together; unfortunately, no one will be immune from Eurozone influenza.


  1. Very scary situation the world is in...

    Question about the new ECB reserve ratio of 1%: Is this the ratio that banks are required to hold in total deposits after lending? Isn't this ratio closer to 10% for North America?


  2. The real problem is,how are they going to do it without a run on Euro...China is going to pickup a lot of bonds here,they have no plans to float the Yuan .