How will Draghi find further stimulus?

Last week Mr. Draghi announced that the ECB was committed to finding a trillion Euros of monetary stimulus “soon”. But simple expansion of the central bank’s balance sheet is neither a necessary nor a sufficient condition for creating effective monetary stimulus – and indeed, it seems quite likely that the ECB’s balance sheet is expanding quite rapidly at the moment, with the TARGET2 system expanding once again.

But, as we know from 2010-12, what was in effect unsterilized balance of payments intervention by the ECB in the periphery, did not provide an effective stimulus to Europe, although arguably it did prevent an even worse outcome from occurring. Thus, without TARGET2, peripheral bond yields would likely have headed much higher given the unprecedented balance of payments deficits that these countries were experiencing during the height of the Euro Crisis. Interestingly, when TARGET2 and the ECB’s balance sheet were contracting in 2013 as a result of Germany’s capital outflows, there was in fact an implicit monetary stimulus to the Periphery – and in Euroland, things are not always as they seem.

Mr. Draghi’s current promise is some form of proactive expansion of Europe’s monetary base through either asset purchases or more targeted lending to financial institutions – but a problem for the ECB is that even the sovereign bond purchases that it conducted in the past may not have been entirely ‘legal’ (and that’s not clear until January next year), and it looks as if opposition within the ECB to sovereign bond purchases remains strong. The ECB is of course already attempting to buy asset backed securities (ABS) but there is no particular reason for the banks to sell their holdings of ‘performing’ ABS holdings in favour of receiving more excess reserves on which they then receive negative interest rates. The ECB also wants to buy corporate bonds but there are probably only about €600bn of potentially eligible bonds that they could buy and these are relatively tightly held by pension funds which, for actuarial reasons, would not like to sell them.

In a perfect world, the ECB would be able buy bonds from an entity set up to buy dodgy assets from the commercial banks, similar to the US bad-bank/TARP/Resolution Trust Corporation. This approach could both reduce Euroland private debt levels and ease the pressure on banking system capital adequacy, but looks unlikely given the political and organizational challenges that would face the ECB and Euro Council. This suggests that any easing by the ECB will likely have to focus on extending credit to the banking system if it’s to hit the trillion Euro target.

Meanwhile if counter-cyclical easing of monetary policy is to succeed on a sustained basis, it realistically needs to be coordinated with fiscal policy and the promise of meaningful economic reforms in France, Italy and elsewhere. In terms of scale, to achieve growth, European governments need to expand their combined budget deficits by around €250bn over the next 18 months with investment in IT, education and pro-investment tax cuts. This would make the European budget deficit around €500bn, and this could be not by the ECB but by commercial banks which could use virtually zero-cost funding proved by the ECB. This would represent QE by proxy, with commercial banks gaining the ‘carry’ implied by the positive yield curve slope while funding the deficit and creating money.

With commercial banks creating money that governments then spend directly within the real economy, the stimulus would have greater chance of success than if the ECB merely purchased bonds from the financial system. As the US’ QE3 demonstrated, proceeds of QE without fiscal easing are likely to be ‘lost’ before they reach the real economy because they lead to one or more of increased capital outflows, build-up of banks’ excess reserves, or the funding of unproductive and potentially even counter-productive corporate financial engineering. Fiscal easing must be accompanied by reforms to support efficiency, and there’s the practical challenge that with bond prices so high and commercial banks so worried about capital adequacy, banks might not want to buy more sovereign bonds even if offered “free” funding from the ECB.

Mr. Draghi’s words delivered a small rally in equities and a knee-jerk fall in the Euro – but for them to mean anything over the medium term, they will need to be followed up with actions. We will monitor what happens like a hawk.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla