Market Realist Chronicles: Will European banks start lending?
60 billion euros from the ECB, but will European banks start lending?
One size does not fit all—especially in relation to central bank policy. Quantitative easing (or QE) isn’t always the magic elixir to cure countries of low-growth, deflationary malaise. If you consider QE in the US successful—and by many measures, it has been—then it was a result of a financial system designed to turn stimulus into growth. This isn’t the case in the EU, nor is it the case in Japan. QE’s ineffectiveness is rooted in its financial infrastructure, and the EU needs to pair stimulus with measures that address structural defects rather than chasing short-term gains through forcing the euro to parity levels with the USD.
The US and EU have different financial systems. Driving down interest rates in the US and increasing credit has a positive effect because all doors are connected. Lower interest rates drive down borrowing costs through the corporate bond market, increasing profits and decreasing unemployment, in turn increasing consumer spending. Real estate prices increase as mortgage rates decrease, which in turn creates equity for homeowners, also increasing consumer spending. Increasing consumer spending creates growth. In the EU, these same mechanisms work very differently and actually have the opposite effect. Corporations don’t access the debt markets in the same way, and increasing real estate prices doesn’t increase consumer spending.
So what’s the point of QE in the EU? Perhaps it was a psychological move on EU members’ part to signal to the world that they have the resolve to fight deflationary pressures, no matter how long it takes. The problem is that, no matter what they do, they can’t control falling commodity prices, which have turned low inflation into outright deflation.
By forcing the euro lower, their export market may pick up in the short term, but its sustainability is in serious question. A sustainable economy needs its financial institutions to lend, and the EU’s financial sector is just not doing that. Instead, it’s hoarding cash and stocking up on foreign securities. Credit is already cheap. EU banks are reluctant to lend because there just aren’t a lot of opportunities to go around, a reflection of a deflationary environment. The European Central Bank became the first central bank to go into negative territory on bank deposits in 2014, when it lowered the rate to -0.2%. But bank deposits still increased and lending still flat-lined. Banks make money by lending. When they don’t, it’s usually a sign that their risk reward from lending is too low. More stimulus won’t change that.
A question of strategy
It’s understandable that this was the path the EU took: it was the easy decision. You can compare it to a portfolio manager dressing up his portfolio at year’s end and telling clients, “I own the winning strategy.” That strategy worked in the US. It worked because it was the bold decision to make as the financial world was melting. It was unprecedented. Maybe the bold move here is to just recognize that gluing together Germany and Greece into one financial system is not the right strategy. It’s difficult to make long-term decisions that address financial infrastructure when there are 20 voices all screaming, “What about me?”
Stimulus results in growth when banks lend. The multiplicative power of churning money throughout an economy is the elixir that fights low growth and deflation. It will be very telling to see if European banks start lending as March 2015 approaches. Or will they prefer to hold safer, higher-yielding foreign securities instead?
More From Market Realist
