Wednesday, September 5, 2012

Draghi's Sterilization Makes ECB Monetary Policy Impotent


The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.

In response to concerns about the inflationary risk of more money printing, European Central Bank President Mario Draghi is going to propose "sterilizing" unlimited purchases of government debt for struggling Eurozone countries. A failed government bond auction in Germany this morning indicates why the plan won't work.

Draghi's newest strategy will focus only on government bonds of three year duration or less. These bonds from the peripheral countries have been snapped up by hedge funds in recent trading days driving their yields down considerably. Draghi will apparently also stress conditionality for the ECB's purchases. Governments must agree to ECB control to get aid and must meet the conditions they agree to in order to continue to have their bond markets supported (Greece has been notorious for violating its promises in this regard).

When central banks sterilize transactions, they pump money into one area of the financial system and remove it from another at the same time. Bloomberg reports that there is an estimated 800 billion of excess liquidity in the eurozone banking system. So, policy makers figure there will be no problem draining an unlimited amount out of the liquidity rich north and transferring it to the cash-strapped south. While this sounds good in theory, reality might be a major stumbling block for this idea to go forward.

While Draghi's plan will only be officially announced tomorrow morning, there was already a failed 10-year bond auction in Germany this morning (only the second time this has happened in recent several years). Germany attempted to sell €5 billion in bunds, but only managed to find buyers for €3.61 billion of its debt. The other more solvent credits of the Eurozone such as Finland, the Netherlands and Denmark are also likely to face this problem in the future. It is simply common sense that this will happen. If the size of the money pie isn't being made larger and some people are getting bigger pieces, someone else has to be getting smaller pieces. Lower interest rates in Spain and Italy are going to mean higher rates in the north.

The voters of the northern Eurozone countries may not be amused when they find out how they are paying for the escalating debt problems in Spain and Italy. Retail sales figure released this morning were lower month over month for the whole Eurozone and manufacturing is continuing its contraction. While Spain is in a full-blown recession, the economies of the northern countries are weakening. Higher interest rates there will not help the situation. It should be an interesting meeting of ECB officials tomorrow. 

Disclosure: Not a Central Banker

Daryl Montgomery
Author: "Inflation Investing - A Guide for the 2010s"
Organizer, New York Investing meetup

This posting is editorial opinion. There is no intention to endorse the purchase or sale of any security.


Kristi said...

There is a reason for sterilization, of course. Based on the experience of UK and US, it is being realised that the drawbacks for central banks of opening the liquidity taps further are growing, while the effectiveness of the action is waning. So why to make Germany's voters angrier than absolutely necessary for creating a degree of calm in the financial markets?

Btw, what the European policy makers should do in your opinion? Nordic voters want solutions - at least some of them know the problems, and as you say, they are not amused. At the same time, break-up of the eurozone is not considered as a good answer; the need to write off excess debts would still remain and having common currency still has advantages. In my opinion, the essay of the Wolfson's prize winner was actually not very convincing in the arguments for the eurozone break-up.


The federal reserve has made a terrible mess of things.

Shannon Baker said...

It sounds like an interesting series. I will check it out

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