Central Bankers and Budget Deficits
Once again, the fate of the world or at least the markets rests on the shoulder of two men. Ben and Mario hold center stage over the next few days.
I believe Ben will disappoint and rather than highlighting what can be done, will take this opportunity to preach on fiscal policy and to talk about what can’t be done with monetary policy. It won’t do much damage to the markets, but isn’t going to support the rally in the short term. I will be on Bloomberg TV today at 5 to discuss my reaction to what he actually says and does.
Draghi, on the hand, I think will come through. It will be tricky as the market has decided it wants certain things (ESM banking license, full support along the entire curve, etc.) that are outside of his “mandate” to deliver. So there may some initial disappointment, but I think he will be able to push the market along.
The immediate response of many is that he cannot do anything meaningful. That Spain and Italy are in solvency modes with deteriorating budgets, so what can monetary policy do?
While solvency isn’t the same as liquidity, they aren’t complete opposites earlier. So long as a country or company can borrow new money to repay old money, they don’t have to default. That’s not a strategy I’m advocating, but ever since Lehman, that seems to be policy makers’ first choice. Terms like liquidity and solvency apply to normal markets, not one where there is a deep pocketed buyer who doesn’t have to make rational economic decisions.
The other issue, one that I have spend less time discussing, is just how interconnected the budget deficits, and hence the “solvency” issue, is tied to monetary policy. Monetary policy can reduce solvency risk.
The Fed has dropped the cost of funding for the U.S. in two ways. By lowering the short term rate to zero and engaging in operation twist to buy long dated bonds, we have low rates across the curve. Over time this has reduced the average coupon the U.S. pays on its debt, while extending maturity. With $16 trillion in debt, every 1% reduction in average coupon is $160 billion. With a current annual deficit of around $1 trillion, that cost savings is a meaningful line item. Reducing the average coupon takes time as it is a function of debt rolling over. But with low rates since 2007, it has worked its way into the system quite well – particularly impressive when coupled with maturity extension.
Then there is the direct contribution of the Fed to the income side of the budget. Last year the Fed paid $83 billion to the government in excess profits. That reduced the annual deficit further.
So in the U.S. the Fed and Monetary policy have reduced the current deficit by a very meaningful amount.
So far this hasn’t happened in Spain or Italy. They aren’t getting the benefit of monetary policy slowly trickling into their funding costs. They aren’t getting any “QE” kickbacks where they pay money to themselves. In short, the ECB has failed to provide anything near the support that the Fed has given.
I’m not saying that there isn’t a debt crisis in Europe, there is. But if the ECB had been able to act anything remotely like the Fed, maybe there wouldn’t be? Or maybe a better way of looking at it, is how ugly would the U.S. be if the Fed hadn’t been successful in reducing costs and providing revenue to the government at the same time?
I continue to believe that we are seeing a shift, and before long, the problems in the U.S. stock market will be U.S. problems and we won’t be able to blame Europe for everything.