International Forecaster Weekly

Draghi Fires His Bazooka

Whether or not Draghi was really planning to announce his stimulus program this week, the surprise Swiss franc decoupling of last week left him no choice.

James Corbett | January 24, 2015

There's an old rule of dramatic writing popularized by the great Russian author Anton Chekov: “If in the first act you have hung a pistol on the wall, then in the following one it should be fired. Otherwise don't put it there.”


            It's not clear whether or not European Central Bank chief Mario Draghi is familiar with Chekov's famous admonition, but in 2012 he hung a pistol on the wall. That was when he began the first of many, many promises that if worst came to worst he would be do “whatever it takes” to shore up the Eurozone economy, including “unlimited” bond purchases in an open-ended QE. This promise became known as 'Draghi's bazooka,' harkening back to Henry Paulson's observation during the 2008 Fannie Mae / Freddie Mac crisis that “If you have a bazooka in your pocket and people know it, you probably won’t have to use it.”

            Unfortunately for Draghi, Paulson ended up having to use his bazooka. Lehman went bust just months after his original pronouncement. Even worse for Draghi, Paulson's bazooka wasn't enough to stop the Lehman meltdown. Sometimes a bazooka is not enough.

            For the better part of the last three years the markets have been engaged in a type of cat-and-mouse with the ECB chair. Every time it looks like one of the Euro's peripheral countries is going to default on its sovereign bonds, or any time a banking scandal threatens a Euro-wide meltdown, Draghi steps in with his promises of “whatever it takes,” and the markets calm down, content that the central banker is eventually going to crank up the funny money printing to keep the party going a little longer.

            But the markets can only play that game for so long before they call the banker's bluff. Whether or not Draghi was really planning to announce his stimulus program this week, the surprise Swiss franc decoupling of last week left him no choice. The piper was demanding to be paid. On Thursday he fired his bazooka.

            Surpassing most market expectations, Draghi announced a 1.1 trillion Euro quantitative easing program. Starting March 1st and lasting until at least September of 2016, the ECB will be buying 60 billion Euros worth of assets a month. The purchases will be primarily Eurozone government bonds, and Draghi implied that the program may not end in 2016 if inflation fails to pick up between now and then. Currently Eurozone consumer price inflation is tracking at 0.2%, far short of the central bank's target of just under 2%. The hope is that the extra stimulus will get investors back into Euro stocks and get money moving through the economy again.

            If the first 48 hours after the announcement are any indication, the first part of that equation has already been accomplished. Not only are Eurozone equities and bonds experiencing an unambiguous rally, so are markets around the world, from the Dow, the S&P and the NASDAQ in the US to the TSE in Canada, the ASX 200 in Australia, and markets across Asia from Japan's Nikkei 225 to Hong Kong's Hang Seng (also bolstered by news that China's slowing manufacturing sector is slowing slightly less quickly now). The markets have spoken, and the oodles of hot new central banker funny money is having its effect in driving investors into stocks.

            But this much was perfectly predictable. After all, a bond and stock buying spree and a plunging currency were the results of similar stimulus measures in recent years from the Fed in Washington, the City of London's Bank of England and Tokyo's Bank of Japan. The direct purchase of government bonds by the central bank is designed to drive down yields and force investors into riskier assets. The “whatever it takes” attitude is also meant to reassure investors that inflation really will be coming and they better start spending their money now rather than hoarding it for later.

            Unfortunately, that's where theory and reality begin to diverge. How exactly this equities rally is supposed to translate into productive economic activity is anybody's guess. In the States at least you can make the argument that nearly one-quarter of Americans actually hold shares, so the “wealth effect” of a stock bubble might open wallets on Main Street. In the Eurozone, direct ownership of equities is much lower, from under 15% of the population in France to as little as 8% in Italy. As little effect as the paper wealth of the recent record S&P and DOW levels have had on the average Joe Q. America, new records on the FTSE or the DAX will have even less of an effect on Jacques Q. Europe.

            The real problem is that the devaluation of the Euro that is taking place right now doesn't really have a theoretical floor. The SNB was singlehandedly responsible for keeping a floor under the Euro, but now that the franc has decoupled the Euro is in freefall. While this is momentarily “good news” for markets, all that the surging stock indexes really indicate is that it's going to take more of those funny colored pieces of Euro-paper to buy a stake in an actual productive piece of the economy. When you think about it, there's nothing inherently good about that.

            The real secret is that all of this stimulus of the past 7 years has done nothing whatsoever to bolster actual productive economic activity, and the central bankers know it.

            In June of 2013, Andy Haldane, the Executive Director of Financial Stability at the Bank of England admitted “We've intentionally blown the biggest government bond bubble in history,” adding that “We need to be vigilant to the consequences of that bubble deflating more quickly than [we] might otherwise have wanted.”

            In October of last year, old “Bubbles” Greenspan himself admitted that economic demand is dead in the water and stated bluntly that the Fed's quantitative easing program “has not worked” in helping to boost that demand.

            In October of 2013, even the inventor of quantitative easing himself, Professor Richard Werner, admitted that the measures taken in the name of his concept are not what he had in mind when he wrote his original proposal and will not help the economy. “That's absolutely not what my policy was about,” Professor Werner told the BBC at the time. “In my original article, I specifically argued against either lowering interest rates or expanding central bank reserves. That was my whole point - traditional solutions weren't going to work. Actually, it was a bit upsetting.”

            Two more big name central bankers added their voices to the mix of QE naysayers this week. Former Bank of England Governor Mervyn King decried Draghi's move to fire the bazooka. “We have had the biggest monetary stimulus that the world must have ever seen, and we still have not solved the problem of weak demand. The idea that monetary stimulus after six years … is the answer doesn’t seem (right) to me.” And later the same day the former Chief Economist of the Bank for International Settlements concurred: “QE is not going to help at all. Europe has far greater reliance than the US on small and medium-sized companies (SMEs) and they get their money from banks, not from the bond market.”

            So it seems just about unanimous, even amongst central bankers. Draghi fired his bazooka because he had to, not because it's going to do anything to fundamentally change the state of the European economy.

            So the obvious question is 'How can we actually reset the economy and get back to normal?' Ironically the most honest answer comes from the master dissembler himself, Alan Greenspan, who remarked on the current crisis that “It’s only by bringing the economy down can you burst the bubble.” The catch, of course, is that (as he himself admits) he never had the nerve to do that while he was Fed chair. And so he blew bubble after bubble, a policy that has been dutifully emulated by his successors and his colleagues in central banks around the world. But the piper always comes to collect his dues, and when this game of central banker musical chairs finally comes to an end, it's quite likely that we're going to find out that there are no chairs left.

            Draghi showed his bazooka in the first act and fired it in the second. Chekov would be happy. Now it just remains to be seen whether this play ends up being a tragedy, a comedy or a farce.

Weekly Market Wrap Up