Ad Hoc Commentary – the ECB QE will probably lead to more deflation

Since ECB will announce QE for the Eurozone today, it is a good time to review Irving Fisher’s MV=PQ equation: “…The equation that matters most in QE is Irving Fisher’s MV = PQ. M is the quantity of money, V is the velocity of money, P is the price level and Q is the quantity of goods and services. We note that PQ is the GDP. The notion that printing is inflationary, i.e. printing increases P, implicitly assumes that M increases, and V and Q remain constant. That is far from certain in this global economy…”


According to the financial elites, we need to embark on quantitative easing (i.e. increase M) to avoid deflation (i.e. a falling P). Firstly, let us reiterate that falling prices in Europe is due to the scourge of unemployment ravaging Europe as we write. The good people of Europe, being prudent economic actors, are hoarding cash for a future that looks increasingly bleak. Low inflation and deflation are just symptoms of the underlying jobs problem.


Now we move on to the belief that quantitative easing will increase the quantity of money chasing goods and services within Europe. To be precise, we seek to dispel the fallacy that printing money to buy government bonds will destroy deflation. In fact, introducing QE without moving ECB deposit rates out of negative territory will probably make the deflation even worse. Let us walk through this:

  1. ECB prints money
  2. ECB buys European government bond from X
  3. X has Euros, ECB has European government bonds

Now what should X do with the Euros? Suffer negative rates by placing it on deposit?

“…No economist polled in a Bloomberg News survey predicts the ECB will change its main rates. At the same time, the current deposit rate of minus 0.2 percent would mean the ECB asking banks to sell assets in exchange for cash, which it then charges them to hold. Pacific Investment Management Co. says the ECB should lift the deposit rate to zero to facilitate the functioning of money markets under QE…”


Yours truly believes that we will have two types of X. The domestic X that will refuse to sell their European government bonds to ECB. How can we blame them? Even businesses in America are hoarding cash because they do not know what to do with it, except perhaps buying back shares. What more can we expect about European businesses? If domestic X do not lend to the government, there is no one else creditworthy enough to lend to. On the other hand, the foreign X will probably gladly sell their European government bond holdings to the ECB. These foreign holders of government bonds would probably give thanks to the ECB, and take their money to their respective home countries. If this happens, quantitative easing by the ECB will not lead to an increase of M. Instead it will counter-intuitively lead to a decrease of M. The more foreigners bring money home, the greater the deflation within Europe. Isn’t that just the opposite of what they publicly say they are trying to do?


Central bankers are the smartest guys in the room. In all likelihood, the real reason for the ECB QE is not deflation. The real reason is a probable Grexit this year. We need QE during a Grexit to stabilize the bond markets of countries that remain within the monetary union. The Swiss depeg was likely done for the same reasons.


The political elites are looking at the first order impact of Grexit and concluded that it is manageable. First order impacts are always manageable. That is why yours truly believes that EURCHF depeg is manageable because there are very few derivatives written on that pair. Nobody was in the mood of buying or selling EURCHF derivatives. The subprime was not manageable, not because of the first order, but because that there were too many financial derivatives written on them. The second order impact in the world of credit derivatives lead to the extremes that we saw in the subprime debacle.


The second order impact of a Grexit is not manageable. Think about this. If first order impact of Grexit is bad for Greece, then there will likely be even more austerity in Europe (albeit after a brief QE relief) because nobody wants to be the next Greece. On the other hand, if the first order impact of Grexit is good for Greece, then Europe will break up because Spain and the rest will probably vote the same way at the ballot boxes. This is probably the year Europe gets destroyed. To save her, you need a true change of heart in the Bundesbank, a realization that Europe risks war at its borders, and a new asset class of infrastructure-secured government bonds. Will Europe wake up before it is too late?


Good luck in the markets.