About That ECB QE

As the Eurozone absorbs yet another economic blow, the urge to engage in even more historic debasement via the ECB has heightened, to say the least. The talk about a European “QE” is near endless, as that is about all that is left for them to do. That is itself a powerful statement, lost upon those that are calling for action – if the ECB “needs” to go even bigger after having done so for years and trillions, to no avail, what possible hope is that the “next” step will have anything but the same results?

In a bit of welcome digression, there are voices of reason in the darkness of total monetarism. There are operational considerations that are holding back the ECB as much as “the Germans.” The Fed’s experience with QE2, especially, is very instructive about the downside in such “loose” policy. In other words, QE may not be “loose” policy at all, but rather having stripped the system of valuable collateral (already in short supply) QE in reality ends up as a “tight” stance contrary to all intentions.

That, in the end, doesn’t matter to many QE proponents as they see the rightful job of QE in the first place as a means for psychological manipulation. Bring on the “bond buying” and the expected “boost” of it will more than offset any drain in actual liquidity these people are saying. Yet, the Fed’s experience in April 2011 is a warning that seems to have some European policymakers more than a little shy about engaging.

There is enough reason to believe that a European “QE” would actually be much worse in terms of collateral availability. The ECB has on numerous occasions reduced (or even just flat out ignored) eligibility requirements for its various “emergency” policies. While that sounds like an outgrowth of “loose” policy it is instead simply recognition of a collateral desert. There just isn’t much “good” collateral left on the continent.

To emphasize that point, the ABS “T”-LTRO stands as not just a prod to lend to small and medium businesses, but, with guarantees in place, also as a potential assembly line to manufacture “good” collateral out of nothing. Again, the thought of even needing to do something like this is high indication of the never-ending shortage.

Manmohan Singh, a senior economist with the IMF and one of the few insider voices that recognize the modern system for what it is rather than what it was (in the 19th century), warned today in the Financial Times not to understate the downside of QE in terms of “plumbing.”

The ECB faces other challenges, however. Some of the best eurozone collateral is at the Swiss National Bank, as its balance sheet expanded significantly after the Swiss franc was pegged to the euro in September 2011. This has reduced good collateral circulation in the eurozone, providing lessons for the ECB as it considers a possible QE. More generally, the ECB, as does the Fed, has to consider financial plumbing.

But after issuing the warning, Singh falls into the same trap that has ensnared the Federal Reserve since taper was first a major topic. In talking about an “exit” the Fed took into account the “need” to harmonize money rates with what amounts to a hard “floor.” We know all-too-well their inability to account for that, first with the IOER and then with the reverse repo program. The latter’s failure more recently should fatally sting anyone that suggests a bureaucratic actor in the repo markets can efficiently meet the demands for collateral in what will inevitably be something of a very tight space.

The fact of the matter is simply that a central bank accumulation of collateral is wholly different from other “silos” in that it doesn’t operate in the same manner with the same incentives. It sounds great in theory, to turn loose the vast holdings of otherwise idle bond collateral, but practice has turned out to be something different altogether. When the reverse repo was first announced all the way back in early September 2013, I congratulated the Fed on actually recognizing collateral as a problem before warning:

I am not as sanguine as some about how that might work, particularly in a climate of rising fear, but it does offer the possibility of using the SOMA holdings to alleviate a “market” collateral shortage.

The weak link here is that the entire plan is dependent on the Fed being correct in its perceptions of market conditions and that it can tailor its response to actual functions. It would still be dependent on non-market, bureaucratic decisions, the kind made during the months of tension before actual panic in 2008. It would also introduce an additional collateral “rental” fee that might not be calibrated correctly. In short, this plan depends on the Fed to correctly surmise rough patches and their causes, and then correctly deal with them in effective doses of policy. I don’t see what confidence that inspires.

As it turns out, that is exactly what happened as any confidence in the Fed’s ability to deliver collateral was totally shattered by incompetence of its operation (again, a bureaucratic agency cannot ever be adept at acting under real market design and conditions). The repo market went into what was really a three-month spasm of collateral shortage (on relatively weak volume too) with nary a peep of alleviation from FRBNY.

Yet, that is what Mr. Singh is proposing should the ECB actually resort to full QE.

One way to do so is to allow the good collateral associated with QE that comes to the ECB to be simultaneously lent out through an aggressive “securities lending” programme: the securities will still belong to the ECB but will be lent to the market for short periods. That would potentially lessen QE’s detrimental effect on financial lubrication in the wider markets.

I am very disappointed that Singh, of all people, would give the ECB such an intellectual “out” over QE implementation when the FOMC itself has essentially discarded the reverse repo intent to nothing more than a third-rate afterthought; in other words, they finally admitted it did not do what Singh requires of “lubrication.” To think the ECB can succeed where the Fed failed, and in a tighter collateral environment to start, defies all sense of operational proprieties. It is the same sort of overestimation of monetary capabilities that has kept monetarism going full force despite the re-re-recessions and all manner of financial imbalances and irregularities – monetary capabilities never live up to such hype.

There are a lot of reasons to think the ECB can and will resist a full QE, including the evolution of central banking itself away from such “floods.” The operational constraints on collateral only make the hurdle for undertaking it that much more daunting. And anyone that believes that the psychological boost of going that far is powerful or even exists needs to re-examine all the psychology boosting that has been going on for years and years without any intended lasting and sustainable effect. In short, QE is about all downside with nothing representing offsetting benefits. Like it or not, that is a conclusion that is shared widely internally to all contrary expectations in the media and of financial “participants.”