QE or Fiscal Integration? by Filipe R. Costa

While some were waiting for OPEC’s oil output decision last week, others were preparing for an early Christmas holiday. Not quite so lucky were those working on the next plan to save the Eurozone from going through the dormant state that has been overshadowing Japan for more than 20 years.

Mario Draghi has been working after hours to convince European politicians that something else must be done to avoid the collapse of the Union. While his number two, Vitor Constâncio, was hinting at quantitative easing, as a potential line of future monetary policy action, Mario Draghi was speaking at the Finnish Parliament, urging for the necessity of further integration within Europe.

While everyone has been greedy, waiting for the ECB’s bazooka to solve the Eurozone problems, Draghi clearly urged for further steps toward fiscal integration as a much more important step to avoid future disaster and eventually the collapse of the whole Union.

Everyone seems to be waiting for the magic wand of quantitative easing to solve the growth problems that are hitting almost the entire world.

But, if money printing, without a corresponding increase in wealth, could solve our global problems, Africa would be a very rich continent by now and Japan would have avoided 20 years of stagnation. Some could argue that the Federal Reserve was able to effectively boost growth through asset purchases, but I am not convinced with their data, because, even if it shows improvement, it is substantially not at par with past recoveries.

I could further add that there are reasons to believe that extended QE programs inflate asset prices and may lead to bubbles, which sooner or later will hit the economy again. The ECB acknowledges this secondary effect and is concerned about the rising prices on corporate debt and other debt issues, as investors seek yield under a prolonged scenario of low interest rates. So, it seems unrealistic to think that QE is the only tool we need to build long-lasting growth. Draghi knows that very well and consequently urged for the need to progress with the integration process within the EU.

When a country enters a monetary union, it allows for the transfer of some sovereignty to the union.

Here, the tools that constitute monetary policy are transferred from the national central banks to a newly created central bank. This means there is a central co-ordination of monetary policy and the exchange rate is no longer an adjustment tool between countries within the union. That’s ok, as long as there are other tools.

As Draghi mentioned in his speech, we must allow the automatic stabilisers to do their work. When the economy booms, taxes collected increase and transfers to households decrease; when the economy enters recession, taxes collected decrease while the transfers to households become an important safety tool to prevent a further decline in income. But, the European Union doesn’t allow for these stabilisers to do their work, as it has been imposing rigorous fiscal discipline at a time of recession. Under such circumstances, everyone looks to monetary policy as their savior, and the consequences can only be tragic.

Of course I am not saying that the European Union, by imposing strict finances on national governments, is the evil here.

Many countries, like Portugal, Italy and Greece, just to name a few, have huge debt-to-GDP ratios, as they accumulated fiscal deficits even during boom years. This prevents them from allowing the stabilisers to do their work at a time they are much needed. But this situation highlights one big issue that the European Union will need to address in the future: there is no monetary integration without fiscal integration.

The loss of monetary policy tools represents a burden because the new policy is directed toward the mean. If, for example, the inflation rate rises at 3% per annum in the Eurozone, the ECB should tighten its monetary base. But what happens to Spain, if the country is showing a rise in prices of only 0.3%? There’s no longer any way to quickly adjust relative prices, as exchange rates and interest rates are kept unchanged across Eurozone countries, forever.

Under this scenario flexibility is important. Transfers of capital and labour may be needed to help re-equilibrate the imbalance. But, as Draghi acknowledged, that may not be enough nor desirable. While free capital flows and some labour flexibility may help, if relying too much on the later, we could be at the risk of ignoring some countries or regions, as people would be looking for better conditions elsewhere.

The Eurozone is facing severe difficulty in addressing shocks.

Fiscal discipline is key in giving some margin of safety, to allow for fiscal deficits in recession years. But the best way to assure discipline is by means of transferring sovereignty from the countries toward a federal budget. The reasoning here is the same that applies to a monetary union. Discipline is best kept when you irreversibly impose it.

If the Euro were just a fixed rate exchange system with the national currencies still circulating, I would bet that at this point many of the peripheral countries would have allowed for currency devaluations. The single fact that such devaluations could be at the table would be enough for these countries to suffer outflows to the extent no other option would be available than to let the currency devalue. But such problems are solved through the adoption of a single currency.

In terms of fiscal integration, we just saw that no matter what you impose, the final outcome is always different and fiscal imbalances accumulate. The “market” is always seeking to explore these vulnerabilities. Fiscal incoherence leads to monetary pressures and will ultimately lead to the failure of the Euro.

Draghi’s speech at the Finnish Parliament was mostly centred on the above matters. He has been clearly sending the message that it is not possible to rely on the ECB as a solution to all EU problems, even though he didn’t exclude the possibility of further steps being taken to increase the bank’s balance sheet.

But why has the ECB not yet engaged in monetary easing as other central banks have?

Of course there are legal matters involved, as the ECB’s mandate may not allow for some kind of asset purchases, in particular those involving sovereign debt. But even if that matter were to be solved, the ECB would still face dilemmas.

As recognised by some ECB members, including its Vice-President Vitor Constâncio, corporate debt may be already overpriced, as a consequence of the current expansionary policy. At the same time, the yields on sovereign debt for G10 countries are at record lows and are still very low for many of the Eurozone countries. This hints at a potential bubble forming.

Investors are desperately seeking yield and driving asset prices higher without an assurance that fundamentals are strong. QE further contributes to the problem and erases any risk perceptions from the equation. If the ECB starts buying sovereign debt, investors will jump into the highest yielding countries, as they will not distinguish any differences in credit risk.

When this happens, yields will be flattened, which means some debt will become over-valued and mispriced. Under such conditions prices would no longer reflect fundamentals, a situation that is similar to what happens in the equity market when sentiment is too high. This kind of problem is not faced by the US or Japan, as sovereign debt is all issued by a single central government.

So, if you own assets, just pray for the bazooka to come early next year. For all others, I’m afraid to say that QE isn’t the solution…far from it.