Germans would shoot down a 'Helicopter Mario'
The former Fed Governor Ben Bernanke's speech on November 21, 2002 ("Deflation: Making Sure "It" Doesn't Happen Here") earned him the affectionate sobriquet "Helicopter Ben."
Building on the concepts of Milton Friedman, the Nobel Prize winning economist, that price inflation and price deflation were monetary phenomena, Bernanke espoused Friedman's view that price deflation (the "It") can be prevented and overcome by an aggressively expansionary monetary policy. Friedman metaphorically described the extreme form of such a policy as money being dropped on people from a helicopter.
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Bernanke came pretty close to the "helicopter money" with his virtually zero interest rate policies since late 2008, augmented by monthly purchases (better known as "quantitative easing") of debt instruments issued by government-sponsored enterprises and including, later on, the U.S. Treasury securities.
Following that example, massive asset purchases are now being advised to Mario Draghi, President of the European Central Bank (ECB), on the view that the near-zero interest rates over the last three years have not prevented the euro area economy from a recessionary relapse and a steady deceleration of consumer prices to 0.3 percent in August from 1.3 percent in the same month of 2013.
ECB's broken policy transmission
Before following asset purchase policies practiced by the Fed, I believe the ECB might wish to address the reasons why the transmission mechanism of the cheap and abundant loanable funds it keeps supplying to the banking system fail to find their way into strong business and consumer lending to support the euro area recovery.
I think there are three main reasons for that.
First, there is a weak loan demand in an area suffering from huge unemployment -- 11.5 percent in July, only marginally lower than 12.1 percent in July of last year – and a dismal 0.5 percent average growth of household disposable income over the last two years. The weakness of these two key determinants of the demand for money has been an important factor behind the falling bank lending to the private sector. In the first seven months of this year, these bank loans have been declining at an average annual rate of 2 percent.
Second, the slowly recovering euro area banks have been unable and/or unwilling to expand their balance sheets with claims on clients without credible collateral, i.e., borrowers without jobs, or with unstable employment, and weak income profiles.
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Third, the euro area banks have also been undergoing apparently stringent asset quality tests in the run-up to the ECB's new supervisory and regulatory functions on November 4, 2014.
The latest news is that the euro area banks have been doing well on these asset quality tests. Official reports indicate that they added some €197 billion to their capital since June of last year.
German doubts echoed by G-20
The ECB's vice president says that this is a "big success," but, true to form, that's not good enough for German regulators. They are complaining that these additions to euro area banks' capital structure are not of good quality.
What are banks to make of this apparently confusing and contradictory evaluation of their efforts to rebuild and strengthen their balance sheets? And is it any wonder that, under these circumstances, they remain gun-shy about their core business of lending to households and corporate clients?
Clearly, the ECB should lift these uncertainties before printing more money.
What happened last Thursday (September 18, 2014) is a case in point. The ECB conducted an allocation of nearly zero-interest loans to banks in an effort to increase their lending to the private sector. But it appears that the number of banks (255) willing to participate in this operation was much smaller than anticipated, and that the €82.6 billion they took from the ECB was only about 60 percent of what bank analysts were expecting.
It remains to be seen, therefore, whether the ECB's decision to boost its balance sheet to €2.7 trillion from the current €2 trillion with these lending operations and purchases of asset-backed securities will restore the intermediation process to provide some traction to its monetary policies.
The Germans apparently fear that all this additional liquidity is unnecessary and that it will merely feed equity and real estate asset bubbles. They also see problems in the banking system down the road. In their view, the abundance of cheap money will relax banks' prudential standards and boost profits, while presenting taxpayers' with huge bailout bills when the banks get in trouble.
At the moment, the German warnings don't seem to be widely shared within the euro area.
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And neither do most German euro partners show the same sensitivity to political aspects of the ECB's excessive monetary easing. Berlin correctly fears that cheap and ample funds offer easy ways of budget financing. That relaxes the fiscal discipline – the essential condition for the stability of the monetary union. The easy money policies, they say, also dull the urgency for structural reforms to restore competitiveness, which leads to unsustainable balance-of-payments problems in crisis-prone member countries.
But Germany is getting a broader audience. Its warnings have been echoed last Thursday by the Financial Stability Board saying that loose monetary policies are prompting search for higher yields as investors seem increasingly complacent about credit risks. The communiqué of the G-20 finance ministers and central bank governors meeting in Cairns, Australia (September 20-21, 2014) contains the same warning.
Investment thoughts
The upshot is that Germany will now be strengthened in its quest for monetary stability within the euro area. That will make it very difficult for the ECB to flood the market with more liquidity through unnecessary and unconventional monetary policies.
And that's the way it should be. The euro area's weak economy needs no additional liquidity. It needs a properly functioning monetary transmission mechanism to channel already available funds to businesses and households -- and it needs a more supportive fiscal policy.
On this last point, Germany will have to relent on its euro area austerity drive. With balanced public sector accounts and a whopping 8 percent of gross domestic product trade surplus, Berlin owes it to its euro partners to strongly boost its domestic demand.
If, with all these warnings, you are reviewing your portfolios, please note that equities offer enough means for an appropriate risk management without a wholesales move into cash positions.
Michael Ivanovitch is president of MSI Global, a New York-based economic research company. He also served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York and taught economics at Columbia.