The One Dollar Euro

By: Andrew_McKillop

NOT A CENT MORE
In the years preceding the introduction of the euro dozens of meetings, conferences, books and PhD theses were focused on what rate against the dollar would be optimal. The favored figure was $1.17 but given today's macroeconomic, fiscal and geopolitical context $1 would suffice. To be sure, when the ECB has to raise interest rates, this may push the euro back up. Conversely, an euro held at an artificially high rate against the dollar can only further intensify Europe's economic slump and deflation crisis, and the directly related “bad bank” crisis.

November 13, the single European currency dropped as low as $1.3391 from $1.3455 just minutes after ECB executive board member Peter Praet said in an interview with leading journals that "If our mandate is at risk we are going to take all the measures that we think we should take to fulfill that mandate. That's a very clear signal". He was referring to Europe's economy being so weak that “achieving” a target rate of 2% inflation is no longer possible. Recent Eurostat data places inflation at 0.7% for the year to Oct 31 in the eurozone but several economists say this number is itself overestimated, and in several PIIGS countries the rate is already 0% or less..

Economists at French bank BNP have said the ECB should buy €50 billion ($67 billion) per month of government bonds of euro-zone countries and start doing this "soon”, to head off a potential slide of inflation to zero percent, or lower, in the 18-nation region. Mr. Praet rejected fears, particularly in Germany that ever-lower ECB borrowing rates harm savers by reducing the interest they earn on deposits. “Creditors and debtors always have an interest in a stable anchor, which is price stability in the medium term," Mr. Praet said, adding the ECB rationale that near-zero inflation and near-zero interest rates reduce uncertainty on future prices and rates and are a “good climate for savers."

Mr Praet is not alone on the ECB executive board by hinting the central bank is ready to apply what some analysts see as the strongest, and most controversial option: direct purchases of “troubled assets” from European banks, or despite the political challenge, buying the treasury bonds of “troubled countries” to reduce borrowing costs in the private sector. "The balance-sheet capacity of the central bank can also be used," said Mr. Praet, meaning the ECB could make outright purchases if it decides. After last week's unexpected ECB key lending rate cut to 0.25%, a record low, other options apart from direct asset purchases, either from private banks or governments, are mainly theoretical.

WE STILL HAVE ROOM
The October inflation report fanned fears the eurozone may slip into “excessively low inflation” or even deflation. Keynesian theory holds that deflation cripples economic activity by holding down wages and cutting profits, and above all makes it harder for governments and the private sector to avoid debt obligations using inflation to cut the real cost of their debt.

Another comment made by ECB member Praet was that the ECB's board believes it can do more if necessary. He said that the “standard measure” of interest rates – still positive even if only 0.25% a year – can be cut. Praet specifically cited the ECB's deposit facility, in reality an obligation for private banks to “park” funds with the ECB on a regular basis. This overnight and short-period bank rate has been set at zero for several months. Making it negative would effectively levy a fee on all commercial banks that park funds at the ECB. This would force them to lend to the private sector and consumers.

In Keynesian theory, this would spur bank lending to the private sector, which would boost growth and then also inflation, but its immediate impact would be to cut private bank profits.

In turn, this strategy could rapidly boomerang, with still-convalescent and undercapitalized private banks with large amounts of “troubled assets” on their balance sheets again needing emergency bailout support from the national central banks of their home countries - or from the ECB. Yet another already mooted possibility for the ECB is to relaunch and increase its long term refinancing operations or LTROs in favour of private banks in Europe. Early LTRO action by the ECB in the immediate wake of the 2008 crisis was tiny relative to the US Federal Reserve's action, but by February 2012 ECB LTROs had attained 529 billion euros in ultra-low interest loans to a total of 800 troubled, and other, banks in Europe. Similar in reality to so-called “repo loans”, which are very short-term and are used by the US Fed and ECB almost exclusively to aid troubled banks, ECB LTROs have in some cases been as short-term as six months, operated on the same basis of using a wide range of private bank collateral – often “junk assets” - to guarantee the loans.

Another possible step – but charged with political danger – would be for the ECB to directly buy government bonds of troubled countries, moving up one notch from buying the assets of troubled national private banks. The ECB would directly buy national treasury bonds, like the US Fed.

Jens Weidmann, who heads the German central bank as well as serving on the ECB's Governing Council, opposed the ECB's decision last year to create a program to buy government bonds. The ECB has no mandate to do this. To date, this program has not been operated but its future potential operation is widely credited with helping calm the eurozone bloc's debt crisis. The ECB's charter forbids it from financing governments, and Mr. Praet said the bank must respect such legal constraints. However the rules "do not exclude that you intervene in the markets outright," he said.

NEW ROLES, OR ENDGAME FOR THE ECB?
By November 2014, the ECB is set to directly regulate eurozone private banks as the first part of a plan for European banking union aimed at heading off future banking and financial crises. The ECB plans to run its first private bank asset quality reviews in the first half of next year, followed by stress tests which will define when banks have “troubled and non-performing assets” under certain shock scenarios. Results are due in October, but this avoids the major political problem – European banking union has to be achieved and national governments have to decide at what point they will step in with taxpayers' funds to bailout “troubled banks”, or wind them down, after ECB testing and identification.

Lack of movement on this subject sets major risk for the ECB itself. Several ECB advisers, and the influential German economic adviser to Merkel, Wolfgang Franz have said that a botched  exercise would undermine the ECB's credibility as bank supervisor from day one, with adverse consequences also for its credibility in its key monetary policy role – keeping eurozone inflation low. They advise the ECB to hive off the bank supervisory rule to a supranational agency, but this would need a new European treaty, and would at minimum take 3 years.

The dilemma for the ECB, as well as other central banks and money authorities in Europe is becoming very simple. Europe faces Japan-style stagnation as governments delay reforms and the ECB exhausts its “conventional options” for speeding economic recovery. This is the opinion of many observers, such as Clemens Fuest, president of the ZEW Center for European Economic Research in Germany. As Fuest and others say, the ECB is presently “shunting problems down the road” and creating a de facto “Japanese situation”. Critics of the ECB go on to say the bank has used up all its ammunition and instead of being a solution to the crisis, is now a part of it.

Using the “big stick” of negative interest rates, that is a levy, on overnight and short-run private bank deposits with the ECB, to force the private banks to lend to industry and consumers, is in fact a radical, or desperate strategy. The US Federal Reserve and Bank of Japan have avoided negative deposit rates, and the Bank of England's Deputy Governor Paul Tucker said last month they are “most unlikely” to be deployed in the U.K.

Denmark is currently the only country in the EU to have a rate below zero. When or rather if the ECB announced it was moving to negative rates on private bank deposits this would be a “very negative signal” in the consensus opinion of analysts. It would signal that the ECB is at one and the same time prepared to push private bank costs up and profits down, and run the risk of more and further bank failures, in its very uncertain quest to restore inflation – not even growth, but inflation – in Europe. Eurostat data shows that GDP in the 17-nation eurozone fell again in the 3 months to end-October. GDP fell 0.2 percent in the three months through March, the sixth consecutive quarterly decline. With unemployment at a record 12.2 percent and a widening gauge of services and factory output signaling contraction, the ECB’s scenario of a gradual economic recovery in the second half of the year is increasingly unrealistic. Among its wild card options, cutting the euro's value may be tried.

By Andrew McKillop

Contact: xtran9@gmail.com

Former chief policy analyst, Division A Policy, DG XVII Energy, European Commission. Andrew McKillop Biographic Highlights

Co-author 'The Doomsday Machine', Palgrave Macmillan USA, 2012

Andrew McKillop has more than 30 years experience in the energy, economic and finance domains. Trained at London UK’s University College, he has had specially long experience of energy policy, project administration and the development and financing of alternate energy. This included his role of in-house Expert on Policy and Programming at the DG XVII-Energy of the European Commission, Director of Information of the OAPEC technology transfer subsidiary, AREC and researcher for UN agencies including the ILO.

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