ECB Announces Economic Stimulus Program
On Thursday, the European Central Bank (ECB) unveiled a fairly aggressive bond-buying program designed to revive the stagnant European economy and stave off a potential deflationary spiral. With interest rates already near zero (0.05%) and a negative interbank interest rate of -0.2%, this form of stimulus was the only reasonable alternative left.
The €1 trillion stimulus package (worth $1.12 trillion as of this writing) is composed of monthly €60 million purchases of bonds and asset-backed securities set to last through September of 2016, although ECB President Mario Draghi suggested that the program may run beyond that date if inflation stays low.
Both government and private-sector bonds will be included in the purchases, as well as debt securities of European institutions.
Wall Street responded positively to the ECB’s announcement, with a 1.5% rally on Thursday in both the S&P 500 and the NASDAQ. The Dow also responded with a 260-point gain. Meanwhile, the Euro continued sliding to a low of $1.11 dollars per Euro before experiencing a small recovery at Friday’s closing.
Dividing Up the Bounty – and the Risk
Draghi faced a dilemma that the Federal Reserve did not have when it designed the U.S. stimulus package – how to distribute the bond and asset purchases among the 19 sovereign nations within the Eurozone. The countries in the greatest need of economic stimulus present the highest risk of default (such as Greece and Cyprus), and the more stable nations face greater risk for lesser return.
One ECB compromise was to scale the bond purchases roughly to the relative size of each country’s economy. This places 78.5% of the bond purchases in the four largest economies (Germany, France, Italy and Spain) and limits bonds from Greece, Cyprus, and Portugal (currently ranked as junk bonds) to 5.6% of the total.
Private bond issues of EU institutions will be subject to shared losses, but government bond purchases will be primarily through the central banks of individual nations and isolated from shared losses.
Could the Eurozone Split?
Given the limited injection of funds into high-risk countries such as Greece, can we expect a useful stimulus effect there? The populist Syriza party has won the Greek elections and, should they attempt to renegotiate the terms of their bailout as they have threatened to do, the EU, ECB, and the IMF are placed in a difficult position.
Holding firm on the current Greek austerity program risks a Greek pullout from the Euro (termed the “Grexit”) and a potential slow unraveling of the Eurozone. Forgiving some portion of the Greek debt ensures that other troubled countries will demand the same treatment, as populist anti-austerity movements are gaining momentum in other European countries (especially Spain). Draghi must walk a difficult political and economic tightrope to get the greatest effect out of the stimulus without splitting the Eurozone among its economic fault lines.
The ECB’s action is overall good news for the world economy, and therefore for America’s economy as well. The stimulus package seems to be a reasonable size and duration, and the composition of assets to be purchased is probably the best compromise available – but will the effect of the stimulus be evenly distributed under the ECB’s proportional purchasing approach?
That is a subplot that bears watching, especially if Greek leftists are successful in renegotiating debt terms. If you have investments in a particular country, focus on the effects in that country instead of on the overall Eurozone.
The major downside is a continued dropping of the Euro – an unpleasant situation for U.S. exporters that do business with Europe, large firms with a big European presence, and any Euro-backed investments. On the flip side, U.S. importers of European goods are in great shape. Review your investment holdings to consider those effects and adjust accordingly.
Meanwhile, Wall Street will be watching the effect of the ECB stimulus. The response should be positive – but if for some reason the stimulus is ineffective or so unfairly distributed that it splits the Eurozone, expect a drop in stocks on the premise that the European economy is unable to enact underlying structural reforms in European labor and financial markets.
Long term, we are still concerned that too high of a percentage of the world’s economic recoveries are driven by Central Bank actions and financial manipulations instead of increased manufacturing and robust consumer growth. The structural reform component cannot be ignored.
Larry Summers, the former Treasury Secretary, summed it up by saying, “I think we need to realize the era of central bank improvisation as the world’s principal growth strategy is coming to an end.” There is only so many times the defibrillator can be applied to the world economy before the patient stops responding.