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The European Farce: Part 1 -- ECB to the Rescue


It is only a matter of time before the ECB will be forced into QE-like money-printing schemes.

In the immediate aftermath of the financial crisis, like the Fed, the European Central Bank (ECB) stepped up and made cash available to the notoriously overleveraged banking system. That, in fact, is the basic and most vital function of a "lender of last resort." So, bravo!

But now, given that the hands of the various European Union (EU) governments are tied, and given that budget deficits have to be brought under control, it is the ECB that has, by default, become the supposed white knight that is now expected to somehow recharge the faltering EU economy.

Sorry, but taken to its logical conclusion, this experiment -- like the ones currently underway in the US and Japan -- is doomed to failure.  To their credit, Mario Draghi and the ECB have resisted Fed-like quantitative easing (QE) programs where massive money printing occurs.  But they will soon be forced into it because the tools they adopted at their June 5 meeting simply will not work.

The major tool, or nuance, announced on June 5 was a negative interest rate on bank deposits (reserves) held by the EU banks at the ECB. The theory is that, rather than pay the 0.10% negative interest rate on those deposits, the banks will lend the funds to the private sector.  Let's examine the logic here.  If the banks haven't been making such loans to date, it is most likely because they can't find an adequate risk/return trade-off.  So why will a few basis points make a difference? What is really shocking is that the financial media has adopted the mantra and are convinced this is going to work.

From their viewpoint, the banks have other viable alternatives. Two of them are the following:
  • buy short-term fixed income assets with the ECB deposits (which will drive short-term rates even lower); or
  • charge or increase fees on bank depositors' accounts to make up for the cost of holding ECB deposits.
These two unintended consequences are more likely the result of the new policy rather than a sudden surge in loans to the private sector.

So, it is only a matter of time before the ECB will be forced into QE-like money-printing schemes. Admittedly, such policies may temporarily keep the EU economy afloat, but they are unlikely to stimulate socialist economies where there are few incentives to take risks. Clearly, the results of the massive money-printing schemes in both the US and Japan have not propelled those economies into "escape velocity."  Why would they work in Europe where incentives are significantly lower than in the US or Japan? 

People in Europe are likely to be happy with the easy money and more handouts. The recent European elections, in which the anti-austerity parties gained ground, bear this out.  How else do you explain a 3.2% unemployment rate in Switzerland, in immediate proximity to France (9.7%) and Italy (12.7%) and not that far from Spain (25.1%) or Greece (27.5%)?

To have any chance of economic growth, the euro must fall significantly in value vis-à-vis other currencies, so that exports rise, imports fall, and tourism increases significantly.  It's their only hope.  And it is why it is inevitable that the ECB will adopt significant QE-style policies in the near future.

To read the part two, see The European Farce: Part 2 -- How to Grow GDP.

Editor's Note: Dr. Robert Barone is a Mangaging Partner / Portfolio Manager of Universal Value Advisors.
No positions in stocks mentioned.
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