The shift in currency relativities that has been occurring since the European Central Bank unveiled its €1.1 trillion quantitative easing program last week is an intended consequence of the ECB program. It is the unintended consequences that are, perhaps, more disturbing.
The obvious intent of the program was to devalue the euro. That is working, with the euro sliding against other major currencies even before the ECB formally announced it would buy €60 billion of European government bonds a month indefinitely.
There had already been a realignment of currency values occurring, with the end of the US Federal Reserve Board’s bond and mortgage-buying last year and an expectation of rising US official interest rates sometime this year pushing the US dollar up against most other currencies.
The impact of the divergence between US and European monetary policies has been seen quite starkly in the value of the Australian dollar, now below US79c but strengthening modestly against the Euro.
The potentially more significant issue, however, is the unintended consequences of the ECB’s policy.
The US QE program saw the Fed’s balance sheet expand by more than $US3.5 trillion as it attempted to encourage rises in asset prices and flow-on effects from rising asset prices and cheap liquidity to the real economy.
Despite the recovery in the US economy, opinion is divided as to how significant a role QE has played in it after the initial infusion of liquidity helped lubricate and calm a financial system that froze in 2008.
Around the world corporates and households de-leveraged despite the availability of cheap credit and the most visible effect of the money-printing was a massive increase in financial activity and volatility as investors accepted increasingly exotic risk in pursuit of positive returns.
Institutions everywhere, it seems, were constructing carry trades based on, initially, near costless US funding and subsequently similarly cheap yen funding after Japan embarked on its version of QE.
It is noteworthy that the IMF said last year that, after shrinking slightly in 2008, the shadow banking sector -- intermediation by non-bank institutions -- has continued to grow and by the end of 2013 controlled about $US75 trillion of assets. In the US the shadow banking sector is estimated to be about 180 per cent the size of the banking sector.
QE is only part of the explanation for the continuing diversion of financial activity into the shadows of the less regulated parts of the global financial system. The other, obviously, is the bank regulators’ responses to the financial crisis and the continuing ratcheting up of bank capital and liquidity requirements now occurring.
In any event, the combination of the previous QE programs has exported ultra-low interest rates to the rest of the world, as well as massive capital flows and volatility. It has also, arguably, generated bubbles in many asset classes.
Some, like commodities, have collapsed, while there is an argument that the end of QE and the prospect of rising US interest rates have played a role in the extent of the plunge in oil prices. There was a significant element of “financialisation” of commodities encouraged by the QE programs.
The eurozone is now the latest of the major economic regions to join the currency wars. Devaluing the euro obviously improves Europe’s competitiveness.
There’s an interesting question as to how that might play into the Fed’s thinking about the timing of US rate rises if the US dollar keeps rising and threatening to undermine US competitiveness and growth, but a more directly euro-centric query is whether it will generate economic growth within Europe.
With fragmented bond markets that have relatively shallow liquidity and economies that rely on bank lending to small and medium-sized businesses far more than the US, Europe’s banks are trying to shrink their balance sheets to improve their capital adequacy. They are unlikely to go on a lending spree, just as the US banks didn’t respond to the Fed’s QE programs by dramatically expanding their balance sheets.
With pre-QE interest rates already at remarkably low levels, there also have to be doubts as to whether the ECB program will have a material impact on real economies within the eurozone, (although it has probably smashed Switzerland’s after the Swiss central bank was forced to remove the cap on the franc and the Swiss Franc soared).
The ECB program will, however, push near-costless money into financial markets, and not just Europe’s. The ‘unintended’ consequences would be to keep some asset prices, most likely equities and bonds, inflated (or inflate them further) and generate flows of funds into unexpected places.
Given the likely divergence in rates and policy between the US and Europe, increased volatility is likely to be a by-product of the ECB program.
It is also probable that European shadow banking (the size of Europe’s shadow banking has been about a third of that of the US) is likely to expand further, while the euro and yen will be the funding currencies of choice for the carry traders.
A likely strengthening of the US dollar and rates if the Fed does start to normalise its monetary policies will add another layer of complexity, risk and volatility to financial markets.
No one seems to know when or how central banks will be able to restore more conventional global monetary policy settings or what the unintended consequences of the prolonged period of unconventional policies might be when they do try to normalise them.
The potential for something ugly -- another Lehman Brothers moment, when the global system was on the verge of melting down in 2008 -- is on regulators’ minds.
The OECD’s William White recently described the world as “dangerously unanchored” in an interviewed with the UK newspaper, The Telegraph.
“We’re seeing true currency wars and everyone is doing it and I have no idea where this is going to end,” he said.
“It ain’t over until the fat lady sings. There are serious side-effects building up and we don’t know what will happen when they try to reverse what they have done.”
Now that the ECB has joined the currency wars it would seem reasonable to assume that those side-effects will continue to build, the day of reckoning (if there is to be one) has probably been pushed out further and the consequences of something going wrong when the central bankers do try to begin extricating themselves from their monetary policy experiments would be scary.