Quantitative Easing is Not the Cure to What Ails Europe

“This is definitely a threat on the horizon,” said Blaise Ganguin, the agency’s European credit chief.

Some 75 companies large enough to be rated face likely default in 2010 as the slow-burn effects of the crisis hit home. The default rate peaked near 13pc this year, the highest since S&P began to collect data.

This is how a recent article by the always apocalyptic Ambrose Evans-Pritchardt.gif begins. At issue is the fragility of economic recovery. I have made a lot of noises about government being the only thing sitting between the U.S. economy and depression (see comments in this post). But, the same is also true in Europe, where an anaemic recovery will hit stall speed without more support. For example, Edward Hugh thinks we could see a double dip in Germanyt.gif. The Germans are on to this and Chancellor Angela Merkel is talking about yet more stimulus according to a recent Evans-Pritchard articlet.gif.

Evans-Pritchard writes further:

The shortage of funds will raise borrowing costs for business by an extra 75 basis points, with the risk of a more serious crunch for small companies. “While the worst of the recession may be behind us, the recovery is likely to be extremely shallow,” he said.

Mr Ganguin said capital spending in vulnerable sectors such as automobiles, home furnishing, and forestry may fall by as much as 50pc as they struggle to cope with excess capacity. “These are enormous numbers. It is clearly going to put a dampener on the recovery,” he said.

Mr Ganguin said the severity of problems depends how quickly the Bank of England and the US Federal Reserve step back from quantitative easing. The Anglo-Saxon central banks have between them bought almost $2 trillion of government debt and mortgage bonds. This has propped up the entire global debt market and capped borrowing costs. As the support is withdrawn – and ultimately reversed – bond yields may rise rapidly to uncomfortable levels.

Obviously, Evans-Pritchard in both this article and the German article thinks a monetarist solution of quantitative easing will alleviate the problem. There are significant constraints to more government spending, especially in the Eurozone where governments can’t just print money. Greece is the most flagrant examplet.gif. But is quantitative easing really going to work?

On the first of this very month last year, Marshall Auerback gave a balanced view of the first experiment with QE in a note on Japan’s experiment with quantitative easing. He said:

Japan’s policy makers generally procrastinated considerably in terms of implementing any kind of stimulative measures, as well as prematurely reversing the benign impact of policies which had some earlier success. In terms of monetary policy, the BOJ did not actually embrace quantitative monetary easing until 2001, eleven years after their bubble had burst. Furthermore, the authorities waited until 1998, a full 8 years after the real estate crash, before embarking on a program of banking recapitalization, the upshot being that the traditional mechanisms through which credit was to be intermediated were still severely impaired.

But I am very sceptical any of this could have worked then or will work now. A day later, on this date last year, I expressed my scepticism saying:

The Bank of Japan went on a massive monetary stimulus, the likes of which we had never witnessed to reflate the economy — to little effect. The Japanese had waited too long to begin quantitative easing (QE). To be sure, the carry trade (where Japanese retail investors, companies, and foreign speculators borrowed in Yen and invested abroad in higher yielding currencies) limited the policy’s effectiveness. But, most economists agree that the enormous lag between 1990 and 2001 was deadly.

Present Fed Chairman Ben Bernanke is one of those economists. He was particularly critical of the Japanese and their ineffective policy response. Soon after the Japanese began their experiment with quantitative easing, he delivered his famous “printing press” speech on how a central bank could fight deflation (The Federal Reserve was also worried about deflation, leading to a 1% Fed Funds rate).

Therefore, the main takeaway here was that the Japanese erred in not being aggressive enough, quickly enough. The Japanese should have cut rates sooner and more aggressively and instituted QE more quickly thereafter.

I would like to challenge that notion on two counts. First, I believe that quantitative easing should have been the preferred policy tool from the start if the desire was to reflate the economy. Second, I am unsure that monetary policy is particularly effective in the aftermath of a financial crisis due to credit writedowns and a reluctance to lend by banks as well as debt overhang and balance sheet repair in the private sector.

And given the last post I wrote on AmTrust Financial, you know I expect more writedowns and further reluctance to lend in the U.S. Evans-Pritchard’s article points out the same obstacles in Europe. So I do not share Evans-Pritchard’s views that QE is the route to sustained economic recovery. Had we seen quantitative easing in conjunction with increased private-sector savings and deleveraging in March 2008, it may have worked. But, I believe that QE now is fuelling an asset bubble everywhere.  A recent article by Bloomberg’s Caroline Baum expressing scepticism about the dollar carry trade also shed light on what is happening with all the extra money in the system.

When I hear folks like New York University Professor Nouriel Roubini talk about asset bubbles and “money chasing commodities,” I want to ask, what money? Where is all the money chasing stocks, commodities, high-yield bonds and emerging- market stocks coming from if it’s sitting in banks’ accounts at Federal Reserve banks?

Paul Kasriel, chief economist at the Northern Trust Corp. in Chicago, thinks he has the answer: portfolio shifts.

“Investors, rather than borrowing dollars, are selling U.S. Treasury securities they own, ultimately to capital- concerned/constrained banks, and are then investing the proceeds in higher-yielding foreign government securities,” not to mention lesser-quality stocks and bonds, Kasriel writes in his Nov. 13 Economic and Interest Rate Outlook.

Carry trade or not, there is a lot of money out there looking for a home. QE is creating a bubble in asset prices. It’s liquidity seeking return and its an accident waiting to happen.  Quantitative easing is not the way forward.

Originally published at Credit Writedowns and reproduced here with the author’s permission.