In early February, in a post titled “A Wounded Deutsche Bank Lashes Out At Central Bankers: Stop Easing, You Are Crushing Us“, we showed just how vast the feud between Europe’s biggest – and ever more troubled commercial bank – and the ECB had become.
As DB’s Parag Thatte lamented then, “ECB rhetoric suggests additional easing measures forthcoming in March. While a fundamental tenet of these measures, in particular negative rates, has been to push investors out the risk spectrum, we remind that arguably the impact has been exactly the opposite.” And while the DB analyst has been correct, and now NIRP is widely accepted as a major mistake, the ECB proceeded to not only ease even more just one month after this first DB lament, but in what may have been a direct affront to DB, launched the monetization of corporate bonds, something which as we documented earlier today has now led to the complete disconnect between bonds and underlying fundamentals.
It was also led to daily record low yields for government bonds around the globe.
Last but not least, it has pushed the stock price of Deutsche Bank to levels not seen since the financial crisis as DB suddenly finds itself unable to make money in an NIRP environment.
Which brings us to today, when overnight DB’s chief economist David Folkerts-Landau released a scathing report titled “The ECB must change“, one which blows DB’s February lament out of the water, and in which DB accuses the ECB of putting not only its future at risk, but the future of the entire Eurozone, with its destructive policies.
A quick read of the executive summary of this epic rant reveals just how shockingly bad relations between Germany’s biggest bank and the former Goldman partner have now become.
Over the past century central banks have become the guardians of our economic and financial security. The Bundesbank and Federal Reserve are respected for achieving monetary stability, often in the face of political opposition. But central bankers can also lose the plot, usually by following the economic dogma of the day. When they do, their mistakes can be catastrophic.
Today the behaviour of the European Central Bank suggests that it too has gone awry. After seven years of ever-looser monetary policy there is increasing evidence that following the current dogma, broad-based quantitative easing and negative interest rates, risks the long-term stability of the eurozone.
Already it is clear that lower and lower interest rates and ever larger purchases are confronting the law of decreasing returns. What is more, the ECB has lost credibility within markets and more worryingly among the public.
But the ECB’s response is to push policy to further extremes. This causes mis-allocations in the real economy that become increasingly hard to reverse without even greater pain. Savers lose, while stock and apartment owners rejoice.
Worse, by appointing itself the eurozone’s “whatever it takes” saviour of last resort, the ECB has allowed politicians to sit on their hands with regard to growth-enhancing reforms and necessary fiscal consolidation.
Thereby ECB policy is threatening the European project as a whole for the sake of short-term financial stability. The longer policy prevents the necessary catharsis, the more it contributes to the growth of populist or extremist politics.
Our models suggest that in its fight against the spectres of deflation and unanchored inflation expectations the ECB’s monetary policy has already become too loose. Hence, we believe the ECB should start to prepare a reversal of its policy stance. The expected increase in headline inflation to above one per cent in the first quarter of 2017 should provide the opportunity for signalling a change.
A returning to market-based pricing of sovereign risk will incentivise governments to begin growth-friendly reforms and to tackle fiscal stability. Flagging the move should dampen adverse reactions in financial markets.
We believe that normalising rates would be seen as a positive signal by consumers and corporate investors. The longer the ECB persists with unconventional monetary policy, the greater the damage to the European project will be.
And just in case readers don’t have a sense of what “great damage” from a central bank looks like, DB is happy to provide the imagery: think Weimar hyperinflation and even another Great Depression.
Central bankers make big mistakes too
In the 1920s the Reichsbank thought it could have 2,000 printing presses running day and night to finance government spending without creating inflation. Around the same time the Federal Reserve allowed more than a third of US deposits to be destroyed via bank failures, in the belief that banking crises where self-correcting. The Great Depression followed.
That was a hundred years ago but mistakes keep happening despite all the supposed improvements to central banking, from independence to better data and more sophisticated theoretical and econometric models. The so-called Jackson Hole consensus before the latest financial crisis tolerated credit growth moving out of sync with the real economy in many areas of the world. The prevailing dogma at the time was that traditional measures of inflation were low and those bubbles in asset markets shouldn’t really exist.
The popular dogma shared among central bankers today is that a lack of demand is the source of all evil causing sub-par inflation. Once such a conclusion has been reached, evidence becomes abundant. This is a phenomenon known as confirmation bias in behavioural economics. Other explanations for low inflation today are brushed aside.
People who are convinced they possess the only correct analytical approach to a problem are labelled hedgehogs in the book Superforecasting by PhilipTetlock. Hedgehogs perceive all incoming information through their one seemingly correct lens, making them blind to alternative interpretations.
In the case of the world’s central bankers, strongly held views are then reinforced by group-think. It is no surprise therefore that ECB president Mario Draghi defends his policy by saying that all other major central banks are doing the same –which by the way does not hold for negative rates. And of course, if a problem persists – such as inflation undershooting yet again – this can only be due to further demand shortcomings rather than other factors such as an oil price shock.
A united front, not to mention unparalleled access to data, means central bankers are hugely respected, or at least rarely accused. But criticisms of current policy is growing, particularly in Germany. Finance Minister Wolfgang Schäuble allegedly blames it for half the AfD’s success in recent elections. Two months ago parliamentary groups attacked the ECB for its zero/negative rate policy and suggested Berlin intervenes – in effect questioning the ECB’s independence.
Such a chorus shows that monetary policy lurching to extremes has consequences far beyond the realm of financial markets and the real economy. It is dangerous for central banks not to consider these wider consequences, especially since it might be argued that they lack the mandate to wield such influence on societies and individual citizens.
DB then points out the biggest logical fallacy of any monetary stimulus: by doing “whatever it takes”, or “getting to work”, central bankers merely remove the burden on politicians to do their job. Instead, everything becomes a function of monetary policy and thus, the stock market. No wonder then that every time Obama speak, his first boast is how high the stock market is. However, the good days won’t last.
The benefits from ever-looser policy are diminishing while the litany of distortions, perversions and disincentives grows by the day. Savers are punished and speculators rewarded. Bad companies survive while good companies are too scared to invest. Moreover, governments no longer fear that failure to reform their economies or reduce debt will raise the cost of borrowing. In fact, total indebtedness in the eurozone has been rising, with the reformed and re-interpreted Stability and Growth Pact as toothless as ever. Risk-spreads have all but disappeared fromgovernment bond markets. Badly needed labour, banking, political, educational and governance reforms have been slowed or abandoned.
Another problem is that games of largess and moral hazard are hard to quit. The ECB has become the henchman of ever more demanding markets, with investors already braying for another extension of quantitative easing by September. There is also evidence that current policy reduces the pressure on banks to increase capital and to clean up non-performing loans (NPLs) and thereby keeping unprofitable companies in business.
Incidentally when DB says investors, it means firms such as Goldman Sachs, Mario Draghi’s former employer. Back to DB, which proceeds to excoriate the negative aspects of the ECB’s policies:
While the ECB is right in saying that it is not running out of ammunition – in purely technical terms the recent debate about “helicopter money” suggests as much – it is on shakier ground arguing that policy has worked as intended…. For example, ultra-cheap loans are providing life support for companies which would not be viable under more normal conditions. This has lead to over-capacity – not to mention disinflation – across many industries in Europe, with revenues falling compared with assets. Last year 40 per cent of companies had no top-line growth. It is ironic therefore that many think productivity can be kick-started via even lower rates.
Another clear negative is that savers have no income certainty over the longer-term, given that it has become virtually impossible to achieve real returns on interest bearing assets. Moreover, survey evidence suggests that consumer thinking has been seriously shocked by negative rates. Rather than rejoicing at free money, most see the move as a sign of distress rates – soggy spending data would support this view. Germans, meanwhile, think the central bank is encouraging indebtedness and profligacy instead of thrift and stability.
Indeed, more institutions are beginning to voice their concerns. At its annual press conference, Bafin, Germany’s financial watchdog, warned that low interest rates were a “seeping poison” for financial institutions dependent on interest rates and is concerned some pensions funds might fail to provide guaranteed benefits. BaFin reckons about half of Germany’s banks have a heightened exposure to interest changes and may therefore have to hold more capital. Bundesbank board member Andreas Dombret warned that banks may have to increase charges to their clients.
Yet another place to look if you question ECB policy is Japan. Its central bank introduced negative interest rates in January and they have been poorly received by financial institutions as well as households and corporations. This has been attributed to the surplus in Japan’s private sector and the preference among households for deposits, bonds and principal-guaranteed products. An increase in projected benefit obligations (PBO) due to the decline in the discount rate also hasn’t helped. The negative impact on Japanese financial institutions is clearer still, in the form of higher holding costs on their central bank current account deposits, narrower lending margins and constraints on credit creation. Ominously for Europe, these repercussions are the result of the simultaneous implementation of quantitative easing and negative rates. And this concurrent policy is also damaging to the Bank of Japan’s own finances.
* * *
Longer-term the negative consequence of ultra-low rates and sovereign bond backstops comes from a lack of economic reform. It was not meant to be this way. Immediately after the crisis the implicit deal was that politicians would reduce public debt levels and implement the necessary reforms while the ECB provided them with the necessary time and monetary tailwind.
Some ex-central bankers argue that early on a pattern evolved where governments did not deliver on their tasks so that the ECB, as the life-saver of last resort, was forced to step in ever more aggressively. But it is equally plausible, although impossible to prove, that politicians delayed making hard choices knowing that the ECB would “do whatever it takes”, as it eventually said explicitly. With the risks associated with failure to reform their economies or reduce debt removed, courtesy of the self-appointed purchaser-of-last-resort of sovereign debt, elected politicians have not needed any encouragement to cater to national interests. In fact, six years after the onset of the European crisis total indebtedness in the eurozone keeps rising.
And now the conclusion to this epic rant:
The ECB has – probably with very good intentions – manoeuvred itself into a position where market expectations are having an increasing influence on its policy. This is in part the result of the central bank’s tendency to raise market expectations ahead of policy decisions, thereby putting pressure on council members to deliver.
With its “whatever it takes” stance the ECB has removed incentives for governments to reform and has distorted the market-based pricing of government bond yields. Politicians are also stuck because unpopular reforms would probably see them replaced by more national and euro-sceptic politicians, which poses an even bigger risk for the eurozone.
ECB president Mario Draghi has repeatedly said he cannot make the fulfilment of his job description dependent on whether other agents (that is, politicians) fulfil theirs. But real world is what it is – ignoring the wider consequences of monetary policy led to last crisis.
The German Council of Economic Experts argues that a comprehensive evaluation of all consequences of monetary decisions is a prerequisite for a competent monetary policy. Today the balance of consequences points to areversal in ECB policy.
Why does all of this sound familiar? Oh yes, because we have been warning about all of this since the day the Fed launched QE, and we warned that there is no way such unorthodox policy ends well. Seven years later the chief economist of Europe’s biggest bank admits we were spot on. We expect many more strategists and economist to make comparable admissions, if they don’t already behind closed doors.
On the other hand, “groupthink” as DB calls it, surrounding Draghi and the central planners is impenetrable, and sadly all of this will be ignored. Which is why the only real way this final bubble is resolved, is when it bursts. Which is also something we have said long ago: instead of fighting the central banks, just let them achieve their goals as fast as possible.
Ultimately, it is now too late to change anything anyway, plus the economic, finacnial and social collapse will inevitably come, whether in one month or a decade. The best that those who are paying attention can do is prepare. As for everyone else… they can find comfort in their echo chambers which ignore the reality that their actions create.
That unpleasant truth aside, we find that the now official super heavyweight contest between Deutsche Bank and the ECB may be far more entertaining than even that between Hillary and Trump. Luckily popcorn is still plentiful and cheap. For now.
Source: Deutsche Bank
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