ECB Goes All In with QE

On 5 March 2015, European Central Bank President Mario Draghi announced a €1 trillion quantitative easing program, allocating €60 billion in monthly security purchases until September 2016.
On 5 March 2015, European Central Bank President Mario Draghi announced a €1 trillion quantitative easing program, allocating €60 billion in monthly security purchases until September 2016.

After deciding earlier this morning to keep the discount rate at a record low 0.05%, Mario Draghi, the President of the European Central Bank, announced a quantitative easing programs of sovereign treasury notes, mortgage-backed securities, and covered bonds. The QE program will begin on 9 March with €60 billion of asset purchases until September 2016, totaling €1 trillion ($1.1 trillion). The program will purchase bonds with a negative coupon as long as the rate is not below the ECB’s deposit rate, which is -0.2%, but will not buy more than a 25% share of a bond issue to prevent the ECB from having a blocking majority in case of debt restructuring.

While this sort of economic stimulus failed in the United States with the Federal Reserve’s $3.5 trillion program, the ECB believes that expanding the money supply to increase the Harmonised Index of Consumer Prices, the Eurozone’s inflation indicator, will spur economic growth to a “prosperous level”, which Draghi describes as 1.5% annual GDP growth.

Even though the new 1.5% growth projection for 2015 is abysmal at best, it isn’t certain that the European Union will even achieve that. China, the EU’s largest trading partner, has lowered its GDP growth forecast to 7% for 2015 amid fears of a real estate bubble burst. Additionally, the possibility of a “Grexit”, or Greek exit from the Eurozone, would send Europe into an economic spiral, undermining the viability of the Euro. As stated in previous articles, none of the major problems facing the EU, such as inefficient state-owned enterprises, high tax rates, excessive regulation, and insolvent pension systems, are being rectified by national governments or the EU at-large. As a result, it should not surprise many that the region has difficulty achieving 1.5% growth despite €60 billion a month of asset purchases.

Perhaps the most depressing part of the ECB meeting earlier today were the HICP projections. While the 2015 inflation forecast was lowered to 0% from 0.7% in the December 2014 report, the 2016 forecast was raised from 1.3% to 1.5%. Why did these trends so in opposite directions? Draghi and other members of the ECB’s Executive Board are hoping that “an increase in oil prices will raise inflation to a sustainable level”. The ECB is betting the entire QE program on the prediction that OPEC’s hesitance to cut production will collapse the US shale industry, which can avoid default and liquidation despite a negative cash flow due to extra liquidity in global markets due to QE.

This leaves the question: has the European Central Bank turned into a complete joke? In the same QE announcement, the central bank said that its intention is to be market-neutral, with the hope of creating as little “distortion” as possible. If the ECB would abide by their own claims, the state of the European economy would be nearing a “prosperous level”.


Tsipras, Varoufakis, and the Schäublegang: Pension Crisis Edition

Varoufakis and Schäuble met on 27 February to negotiate a bailout extension for Greece, a nation that already has 360 billion Euros in debt.
Yanis Varoufakis and Wolfgang Schäuble, the finance ministers of Greece and Germany, respectively, met on 27 February to negotiate a bailout extension for Greece, which already has 240 billion euros in debt.

Another day, another chapter in the ongoing Greek debt crisis. While Greece’s T-bill action earlier today was a success, the yield on Greek treasury securities reached an 11-month high of 2.97%, compared to 2.75% on the last auction in February. Another issue of contention is that 262.5 million euros were non-competitive bids, mostly comprised of funds from Greek Social Security accounts.

Concerns over a Greek exit from the Eurozone (so-called “Grexit”) peaked in late February during the Troika-Greek debt negotiation showdown. Yanis Varoufakis, the finance minister of Greece, eventually struck a deal with the Eurogroup. Many in the Bundestag were hesitant to pass the bailout extension, while many in Greece were angry at the SYRIZA Party for reneging on pre-election promises. Despite the opposition in Germany to the extension, German finance minister Wolfgang Schäuble pleaded that “we Germans should do everything possible to keep Europe together as much as we can.” Greece’s exit for the euro could cause major problems for other Eurozone members by undermining the credibility of the euro.

In the past month, many issues have rose from changes in bailout programs between the Troika and Greek government. Since 2010, the European Central Bank has accepted Greek junk bonds and related securities as collateral from banks to assist refinancing operations as long as the Greek government continues fiscal reform and austerity measures. This program ended on 4 February 2015, causing disarray and worry within the Greek banking system. To quell concerns, the ECB extended to scope of its Emergency Liquidity Assistance program to Greek banks to 65 billion euros. The last tranche of bailout from the ECB of 7.2 billion euros requires that Greece meet new budgetary requirements before the assistance is paid out.

The current crisis in Greece originates from poor government policy over the past several decades. A stringent regulatory structure discourages business formation and investment. While this is a major problem across the Western world, it contributes massive weight to Greek economic malaise. Inefficient state-owned enterprises produce poor services whilst adding to budgetary deficits. Conflicting laws in the country’s legal system discourages business production through ill-conceived prosecutions. High taxes on the wealthy have encouraged capital flight and tax evasion, reducing Greek tax receipts.

In order to expiate the debt crisis situation, Greece needs to adopt a hands-off approach to economic management through privatization, deregulation, and a streamlined tax and legal system. Tsipras and Parliament cannot pay off the 240 billion euros in government debt through tax hikes or penalties. The Greek economy needs a period of economic prosperity in order to extend Treasury reserves. While this goal seems impossible at the moment, many nations, such as Vietnam and India, have utilized successful economic reform to their advantage.

NASDAQ 5,000: Are We In Another Bubble?

The NASDAQ 5000 has increased exponentially since the trough of the Great Recession despite low economic growth, leading to the consensus that Fed policy has created another asset bubble.
The NASDAQ Composite has increased exponentially since the trough of the Great Recession despite low economic growth, leading to the consensus that Fed policy has created another asset bubble. Many bull market economists dispute this view, mirroring thoughts during the height of the dot-com bubble.

Given the poor economic performance of the United States in recent years, it surprises many that the NASDAQ Composite has nearly returned to its highs during the dot-com era, which was the longest economic expansion in US history. This regained milestone also poses another question: is the US economy currently experiencing a market bubble?

The March 1991 to March 2001 economic expansion was the longest and largest of any in United States history. US GDP grew at above 4% annually in 1997 (4.5%), 1998 (4.5%), 1999 (4.8%), and 2000 (4.1%). The NASDAQ Composite reached an intraday high of 5132.52 on 10 March 2000, before diving to 1108.49 on 18 October 2002. The combination of the failure of FCC-mandated CLECs, burst of the dot-com bubble, and a flurry of accounting scandals (Tyco, WorldCom, Enron) weighed heavily on the technology-dominated index.

It should not shock many that the US’s economic performance is more dismal than during the dot-com boom. GDP growth was 2.4% in 2014, and has never reached above 3% since the Great Recession. Despite this, the massive accumulation of corporate debt in recent years (especially in the technology sector) mirrors the same trend during the financial crisis. Overvaluations and high price-to-earnings ratios concern many economists.

Peter Schiff, CEO of Euro Pacific Capital, voiced that Uber’s latest $41 billion “valuation is absurd. And there’s a lot of companies like Uber that are sporting these billion-dollar market caps.”  Wild overvaluations are not the only symptom of the current bubble. There’s been a major move to more speculative investments due to low interest rates. This is evidenced by the recent rise in stock buybacks that public companies have facilitated. After accounting for inflation, many savings accounts, certificates of deposit, and Treasury securities generate negative real returns. This will later end in financial capitulation, or flight to quality, as traders will be forced to expunge riskier assets from their portfolio after the bubble bursts.

The Federal Reserve’s $3.7 trillion quantitate easing program was aimed to stimulate investment after the Great Recession by purchasing bank debt, mortgage-backed securities, and Treasury notes. QE has clearly pushed up asset prices above equilibrium levels, causing massive amounts of malinvestment in the economy. The Fed’s only option is to facilitate a discount rate increase within the next year, thus bursting the current bubble.

Economic conditions revolve less around timing of interest rate increases than Fed response to the ensuing financial crisis due to cash flow management difficulties that arise from an increase in debt service costs, among other results aforementioned. My worry is that the FOMC will use the downturn to begin QE4, creating another asset bubble. Poor policy by the Fed in recent years has made many reconsider the central bank’s role in the economy, for better or worse. Perhaps optimal monetary policy will one day set the stage for solid, real economic growth.

Restructuring the Fed

Jerome Powell speaking at an FOMC meeting
Jerome Powell, the only Republican governor on the Federal Reserve Board, has rightly claimed that a Fed audit would be “in violent conflict with the facts”.

Spearheaded by financial reformers such as Rand Paul, the movement to audit the Federal Reserve’s conduct has grown in recent years. One current proposal would subject the Fed’s monetary policy to Government Accountability Office audits. While this is aimed to prevent the creation of asset bubbles that we’ve seen from late-Greenspan, Bernanke, and Yellen, it poses additional problems for the US’s financial system.

Jerome Powell, the only Republican currently serving as a Federal Reserve Board governor, gave a speech on 9 February, expressing worry that an audit would produce “substantial risk of political interference”. Considering the atrocious left-wing, expansionary movement the Fed has made since Greenspan’s exit (QE and ZIRP), further politicization of central bank policy should be avoided at all costs. Powell added that Fed policy is most effective when “rendered independent of influence by elected officials”.

This false panacea does nothing to solve the structural problems that the Fed faces. Dallas Fed Chairman Richard Fisher argued that the Fed was “audited out the Wazoo”. While his statement isn’t entirely accurate as outside institutions have no direct control over the Fed’s open market operations, some truth lies in the claim. The Federal Reserve Reform Act of 1977 forced the central bank to “promote maximum employment, production, and price stability”, establishing direct policy objectives  for the first time. Since then, interest rate policy has become unstable in order to achieve these goals, often causing financial crises.

Aside from the poor policy decisions, which can only be repaired through the appointment of rational governors to the FRB, many structural problems exist within the Federal Reserve System. Many market analysts believe that too much power rests with the New York Fed. Assets and transfer volume are fragmented throughout each of the system’s 12 regional banks. Decreasing the number of banks to six (New York, Dallas, San Francisco, Saint Louis, Atlanta, and Chicago) would concentrate these indicators and decrease the relative power of the New York Fed. After the unsightly burden that Dodd-Frank placed on smaller financial institutions, a reduced number of regional banks could redirect their conduct to verifying the transactions of the largest holding companies, which are typically based in the six aforementioned cities.

To further inhibit the political implications placed on the Fed, the Presidents of the six regional banks should be given permanent Federal Open Market Committee voting power. Consolidation of the regional banks and new power in the FOMC will dramatically increase efficiency of the Federal Reserve System’s objectives. The new voting seats also bring a variety of views, notably that of Saint Louis Fed President James Bullard, who warned that failure to increase the federal funds rate would create “some risk” and other options would be “resolved in a violent way”.

Those that advocate abolition of the Federal Reserve fail to realize two key points. When a country has a nationalized currency, like the United States, a central bank is needed to ensure the limited stability of the currency. Combined with a fractional reserve banking system, a central bank provides liquidity to financial institutions.  Privatization of the world’s currencies is the best option of reform, however this is politically impossible for at least the next two decades. In the meantime, the Federal Reserve needs to be operating in the most efficient manner in order to ensure proper function of financial markets.