The guest commentary below was written by written by Daniel Lacalle. This piece does not necessarily reflect the opinions of Hedgeye.

The ECB’s Latest Big Mistake - ECB cartoon 03.11.2016

One of the great mistakes among economists is to receive the measures of central banks as if it was the revealed truth. It is surprising and concerning that it is considered mandatory to defend each one of the actions of central banks.

That, of course, in public. In private, many colleagues shake their heads in disbelief at the accumulation of bubbles and imbalances. And, as on so many occasions, the lack of constructive criticism leads to institution complacency and a chain of errors that all citizens later regret.

Monetary policy in Europe has gone from being a tool to help states make structural reforms to become an excuse not to carry them out.

The steady funding of deficits of countries that perpetuate structural imbalances has not helped strengthen growth, as the Eurozone has seen constant GDP estimate cuts already before the Covid-19 crisis, but it is whitewashing the extreme left populists that defend massive money printing and MMT, threatening the progress and growth of the eurozone. Populism is not fought by whitewashing it, and the medium and long-term impact on the euro area of this misguided policy is unquestionably negative.

Today, citizens are being told by numerous European extreme left politicians that structural reforms and budgetary prudence are things that were implemented by evil politicians with malicious intent, and the message that there is unlimited money for anything, whenever and however is whitewashed by the central bank actions.

It is surprising to hear some serious economists at the European Central Bank or the Federal Reserve say that they do not understand how the idea that money can be printed eternally without risk is spread all over the political debate when it is central banks themselves who are providing that false sense of security. The central bank may disguise risk for a time but does not eliminate it.

Greece, Cyprus, Lithuania, Slovakia, Spain, Portugal, and Slovenia are already borrowing at negative real rates. However, negative rates are not a sign of confidence in the government policies, but an aberration of monetary policy that hides the real risk. And sooner or later, it bursts.

When politicians say that negative yields reflect the confidence of markets in the country it is simply lying. The ECB is on its way to own 70% of outstanding sovereign debt in the eurozone and buys all the net issuances after redemptions, according to Pictet and the Financial Times. There is no market.

This temporary confidence in the capacity of the ECB to alter risk is only sustained if the euro area grows its trade surplus and its economic output, but mostly if Germany continues to finance it. It is not eternal; it is not unlimited, and it is definitely not without risk.

Many readers will say that this is an exceptional policy due to the Covid-19 crisis which requires exceptional measures. There is only one problem with that argument: that it is false.
The ECB’s policy has been ultra-expansive for more than ten years, in crisis, recovery, growth, and stabilization periods. Interest rates were cut to negative and asset purchases extended in growth and stable periods where there were no liquidity risks in the economy.

In fact, the European Central Bank has become hostage to states that do not want to reduce their structural imbalances but aim to perpetuate them because the cost of debt is low, and the ECB “supports” them.

The ECB should be worried about the fact that the most radical parties, many aligned with the economic policies of Argentina and Venezuela, like Podemos or Syriza, cheer this monetary insanity as a validation of their theories.

It is no coincidence that the reformist momentum in the Eurozone has stopped abruptly since 2014. It coincides exactly with the massive liquidity injections. Structural reforms and budget prudence are perceived as evil policies. Low rates and high liquidity have never been an incentive to reduce imbalances, but rather a clear incentive to increase debt.

The big problem is evident. Once in place, the so-called expansionary monetary policy cannot be stopped. Does anyone at the ECB believe that states with a structural deficit greater than 4% of GDP per year are going to eliminate it when they issue debt at negative rates? Does anyone at the ECB honestly believe that, after the Covid-19 crisis, governments will cut bloated budgets? Dozens of excuses will be invented to perpetuate a fiscal and monetary policy whose results are, to say the least, disappointing considering the enormous volume of resources used.

The worst excuse of all is that “there is no inflation.” It’s like driving a car at 300 miles an hour on the highway, looking in the rear-view mirror and saying, “we haven’t killed ourselves yet, accelerate.”

It is not a surprise that the eurozone has witnessed a rising number of protests against the increase in the cost of living while the central bank tells us that “there is no inflation”, but it is also, at least, unwise to say that there is no inflation without considering the financial assets that have soared due to this policy.

Insolvent countries with negative-yielding 10-year sovereign bonds is huge inflation. Rising prices for non-replicable goods and services, which in many cases triple the official inflation rate is huge inflation. Large increases in rent and housing are not adequately reflected in official inflation. It is especially worrying when monetary policy encourages unproductive spending and perpetuates overcapacity. This means lower productivity growth, which means lower real wages in the future.

A recent study by Alberto Cavallo of the Harvard Business School warns of the differential between real inflation suffered by consumers, especially the poorest, and the official CPI (consumer price index). Take, for example, the Eurozone CPI for November. The figure is -0.3%. There is no inflation, right?

However, in the same data, fresh food rose 4.3%, services 0.6% and the energy component fell 8.3% yet no European citizen has seen a drop in the 8.3% on their energy bill, because neither gasoline nor natural gas or electricity including taxes have fallen so much.

In fact, if we analyze the cost of living using the goods and services that we really use frequently, we realize that in an unprecedented crisis such as that of 2020, prices for the middle class and the poorest layers rise much faster than what CPI shows, and that, added to the distorting factor of the enormous inflation in financial assets, generates enormous social problems.

When the ECB ignores demographic trends (longevity reduces inflationary pressures), the effect of overcapacity and technology and launches trillions of euros that inflate financial assets and public debt, accumulated risks are much greater than the supposed benefits that the policy can generate.

All these perverse incentives and errors would be solved with a Taylor rule that would prevent the central bank’s discretion.

  1. Focusing the measures on concrete results and data and, thus, delimiting the action is key to mitigating – albeit not eliminating – perverse incentives. There is a huge difference between criticizing central banks doing everything at any cost without control and saying that they should do nothing.
  2. Additionally, the central bank must give clear and definitive guidelines on the timing and maximum size of the measures. We saw one of the most dangerous perverse incentives in 2018 when, faced with the possibility of a moderate normalization of monetary policy, states and investors forced the hand of central banks to continue with massive injections. In less than two months, central banks changed their policy by 180 degrees.
  3. The role of the central bank is not to combat climate change or justify unsustainable budgets. It is to function as a guarantee of liquidity, not a guarantee of low cost, much less a guarantor of first resort. It is terrifying that European states that already issued bonds at negative real rates before the crisis would collapse due to a meager increase in the cost of debt of 0.5%. It shows the severity of the bubble created.
  4. The role of the central bank is not to bail-out investors and governments that play “the worse, the better” strategies, buying the riskiest assets or spending uncontrollably assuming that monetary policy is going to bail them out forever, but to avoid that these leveraged bets to spend without control and buy garbage are not generated or, at least, not incentivized.
  5. The role of the Central Bank is not to copy the imbalances of others. The ECB is not the Federal Reserve, nor is the euro the world’s reserve currency. The ECB’s balance sheet already weighs 61% of the eurozone’s GDP, while that of the Fed only 34%. Policymakers cannot play dangerously with the credibility of the eurozone in the long term just because in the short term “nothing happens” according to them, especially when it does.
  6. Supporting the recovery is not supporting structural imbalances, much less unproductive political spending. The objective of a central bank is not for a state to finance any expenditure at artificially low rates. It compromises the central bank independence and generates enormous negative effects on citizens in the medium term, by eroding real wages and productivity.
  7. Something that does not work well in growth periods is not failing because of not doing more. The surplus liquidity at the ECB is more than 3.4 trillion euros. It was already more than 2 billion in a growth period. If monetary policy has not worked, it is not because it is a problem of injecting more liquidity, when there is clearly an excess, but of solvency. And that is not solved with a policy that encourages debt, penalizes prudent savings, and perpetuates zombification problems with artificially low rates. It is no coincidence that the percentage of zombie companies has skyrocketed in times of growth with negative rates.
  8. A monetary policy that generates bubbles and financial risk is not solved with the same insane policy but destroying the purchasing power of the currency. If monetary policy has not worked, it is not because MMT-style Venezuelan or Argentine “money for the people” policies have not been implemented, but because productive investment and sustainable growth come from savings and prudence with risk, not from runaway spending and debt. A problem of perverse incentives is not solved with one of greater destruction and impoverishment.

The fact that, for now, enormous risks are not perceived – or not perceived by the central bank managers – does not mean that they are not building. Negative-yielding debt, which has reached a record $ 18 trillion globally, led by the eurozone and Japan, is not a sign of confidence, but rather a huge risk of secular stagnation.

When the central bank leaders argue that they only offer a tool but at the same time they give fiscal and budgetary policy recommendations encouraging “not to fear debt” and spending much more, not only does the central bank lose independence in the medium term, but it is the same as a waiter who does not stop serving you drinks, encourages you to binge and then blames you for being drunk.

Introducing these huge imbalances has significant risks, and they are not my speculation of the future. They are realities today. The huge disconnect between financial assets and the real economy, insolvent states financing themselves at negative rates, bubbles in housing and infrastructure assets, debt from zombie companies or junk debt with historical-low yields, aggressive increase in leveraged investments in high-risk sectors, the perpetuation of overcapacity, etc. Ignoring all these factors in a monetary institution is more than dangerous, it is irresponsible.

It is not time to do everything at any cost whatever happens. It is time to defend sound money or the credibility of institutions will sink even further as the mainstream consensus chorus sings Hallelujah while the building collapses.


This is a Hedgeye Guest Contributor note by economist Daniel Lacalle. He previously worked at PIMCO and was a portfolio manager at Ecofin Global Oil & Gas Fund and Citadel. Lacalle is CIO of Tressis Gestion and author of Life In The Financial MarketsThe Energy World Is Flat and the most recent Escape from the Central Bank Trap. This piece does not necessarily reflect the opinions of Hedgeye.