So, Mr Draghi, What Will It Take Now?

Having talked up the ECB's willingness to exert itself to drag the Eurozone away from the deflation danger-zone, it is difficult to imagine what Mr Draghi and colleagues can come up with this week which the markets have not already discounted. (If so, perhaps the ECB's best bet is to do nothing and watch the currency slide in disappointment.)
The two most widely trailed proposed actions are:

i) to slap negative interest rates on deposits which the Eurozone's commercial banks keep lodged with the ECB;
ii) to engineer some sort of funding program for banks, in which preferential interest rates are linked to specific lending targets. 

Both sound good, but both have problems which will render them disappointing and even if not absolutely ineffective.

Imposing negative interest rates on commercial banks' deposits kept with the ECB sounds good, with the promise that these funds will necessarily be driven into risk assets which would otherwise be unfunded. But the policy faces two problems. First, it is mostly too late, because banks have already run down these deposits. Looking at the ECB's weekly balance sheet, we find that banks have only Eu161.2bn of deposits in the ECB which are not needed to cover their reserves ratios. That may seem a lot, but in fact the total has retreated right back to pre-crisis levels:  in January 2010, for example, the average was Eu189.5bn.  The belief that these deposits are a large source of idle funds which may be mobilized stems back to the months of the immediate crisis, when the topped Eu1tr. But those days are long past: that bird has flown. 

But even if this were not the case, the policy would face a second difficulty: were ECB to impose punitive negative interest rates in a bid to drive this money into risk assets, the simplest and safest response by commercial banks would simply be to cut their borrowing from ECB by a similar amount. The latest weekly data shows ECB is currently lending Eu640bn to the Eurozone banking system, a total which has already fallen by Eu195.4bn, or 23.4%, during the last 12 months. Rather than pay interest on those deposits, why not use the money merely to repay the ECB? If commercial banks chose that path, there would be no first order impact on risk assets at all. 

The second proposed policy, offering banks preferential funding rates tied to lending targets, sounds more promising. More, the Bank of England has trialled one of these schemes in the UK, under the Funding for Lending Scheme (FLS), so is not a complete leap into the conceptual dark, and some may assume that it has contributed to the UK's recovery (almost certainly wrongly). But the British experience highlights why any similar Eurozone scheme is likely to labour hard to achieve little. The FLS was launched by the Bank of England the UK Treasury in July 2012, initially for a period limited to end-2013, but subsequently extended in 2014 for a further year. By the end of 1Q2014, some £43.3bn had been lent under this scheme, equivalent to just 2.2% of the UK total sterling bank lending to the private sector. But by now, the scheme is actually shrinking: the total lent fell by £2.66bn during 1Q. More, the scheme has not stopped Britain's deleveraging: in the 12m to March 2014, total lending, including FLS, fell by £67.97bn.

The problem, as the Bank acknowledges is that the problem which FLS was meant to deal with – prohibitive credit spreads – has disappeared in the UK. At its launch in July 2012, the Bank assumed that household and corporate credit spreads would tighten by around 100bps; in fact, by the end of 2013, spreads for households had tightened by about that, but spreads for corporates had come in around 150bps. Since then, spreads have continued to tighten.

The Bank comments: 'It is difficult to assess the Scheme's contribution. . . because of the impossibility of knowing what would have happened in its absence. In the year prior to the launch of the FLS, UK banks' funding costs had risen, in large part because of developments in the euro area. As well as the FLS, subsequent falls in banks' funding costs are likely to have reflected other economic developments and policy initiatives at home and abroad: in particular, comments made the President of the ECB in July 2012 and the subsequent announcement of Outright Monetary Transactions are likely to have played a role, and so reduced UK banks' need to access funding through the FLS; in their absence, it is probable that the FLS would have been more heavily used'.

In other words, the FLS itself was stymied by actions already taken by the ECB.  How much more true will this be for any similar scheme launched by the ECB now. Credit spreads have tightened so dramatically since 2012 that it is difficult to imagine that the ECB's offer of preferential funding can be made to appear sufficient incentive to alter banks' lending policies – even in the event that they can discover an appetite to borrow. In fact, right now, the spread between Euro 10yr sovereigns and BBB credits has closed to under a percentage point – the lowest since at least 2008.  That bird, too, has flown.

The fundamental problem Mr Draghi faces, of course, is that there is a limit to what monetary policy alone can do to address problems caused by economies having both the wrong currency, and the wrong fiscal policy. Sadly, that bird cannot be asked to perform.