VOLUME III ISSUE XLVII

September 16, 2014

Executive
Summary

The ECB Risks Playing

it Too Safe with its
Monetary Policy 2

The Battle for Scottish

Independence Rattles
United Kingdom 5
The European Central Bank is not giving itself much
buffer in its newest steps to combat deflation in the
euro area. Meanwhile, Scottish independence is up for
grabs. With polls unable to predict an outcome with
any certainty, the question remains whether Scottish
and British politicians would even be able to bridge the
gap created by the separation.
Image courtesy of Al-sharq

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VOLUME III ISSUE XLVII

THE OPPORTUNE TIME

September 16, 2014

The ECB Risks Playing it Too Safe with its

Draghi delayed almost a year by providing only

Monetary Policy

passive interest rate cuts in an attempt to allow

the euro area to recover naturally. This risky
gamble failed to pay dividends: inflation in the
euro area has now fallen to a 5-year low of 0.3%,
down 1% from just a year ago. Why was Draghi
seemingly dragging his feet, especially given
that unlike the U.S. central bank, which has
both an unemployment and inflation mandate,
the ECB only has an inflation mandate of 2%
and no mandate for lowering unemployment?
One suspect is pressure from Germany, whose

The International Monetary Fund (IMF) has lent European countries ample funds in recent years. Despite this political leverage, the independent and conservative ECB
has been slow to act to appease even its largest creditors.
IMF Chief Christine Lagarde has warned that deflation in
Europe puts the entire global economic recovery at risk. |
Image courtesy of Bruegels

In

its

September

monetary

policy

announcement, the European Central Bank

(ECB) finally shifted from words to action. Its
President Mario Draghis pledge of doing
whatever it takes to support the Euro was
finally put into action with a limited form of
United States (U.S.) style quantitative easing

leaders have cited various forms of the moral

hazard argument as well as fears of the ECB
taking on too many risky assets that could turn
sour. Another is that central bank stimulus may
relax pressure on European peripheries to enact
structural reforms. Draghi explicitly expressed
this view at a Jackson Hole conference meeting
of the worlds central bankers. Other factors
limiting action so far may be intangibles such as
the conservative history of the ECB, or the
continued belief expressed by its members:
despite the apparent threat of deflation, longterm deflation risk is low.

(QE). It seems that Draghi held on as long as

Although Draghi announced only a limited

possible to keep from starting a stimulus

version of previous attempts at QE, the plan

program, even in the face of increased pressure

represents a major hurdle overcome in bringing

from investors, economists, and even the

the historically conservative ECB to action.

International Monetary Fund (IMF). Despite

Often referred to as QE Lite in media

compelling arguments for aggressive action,

headlines, the reason the ECBs program is

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VOLUME III ISSUE XLVII

THE OPPORTUNE TIME

September 16, 2014

considered limited is because it involves buying

collateralized forms of debt only. This includes
asset-backed securities (ABS) and covered
bonds. Unlike the U.S. and Japan, Europes QE
purchases will not extend to buying sovereign
debt, or debt issued by governments backed
only by faith in their ability to repay bond
purchasers.

The

lack

of

sovereign

debt

purchasing is likely to pose a problem and

prevent the effectiveness of the ECBs stimulus
program. Europes ABS and covered bond
market is rather small, on the orders of billions
rather than trillions needed. Although increased
demand from the ECB is likely to increase these
types of debt issuances and supply more money
and credit into Europes economic system, the
lack of purchasable collateralized debt currently

The iShares Euro Covered Bond ETF has a 6.08% return

year-to-date (YTD), an impressive performance deriving
from the ECBs limitation of buying only collateralized
debt. | Image courtesy of Bloomberg

on the market is going to increase the amount of

time it will take for the QE program to have an

the EUR. Buying assets leaves banks and

effect.

bondholders with cash instead of assets, forcing

The ECBs stated goal by purchasing securities

through open market operations is to increase
the size of its balance sheet. This means that the
ECB wants to raise the amount of assets it is
holding back to the 3 trillion euros (EUR) that it
held in 2012, which is about a trillion more than
current holdings. Why does the ECB want to
expand the size of its balance sheet? It has less
to do with the particular assets that the ECB is
holding, and more-so with the increase in the
money supply that it hopes will put pressure on

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them to hopefully use the cash, driving

economic demand and increasing inflation. In
fact, just the expectation and subsequent
announcement of the ECBs QE-style program
has been enough to significantly lower the
EURs value to a 4-month low against the U.S.
dollar (USD) of $1.29. This shift in the EURs
market value may benefit Draghis cause, since
the bond purchases generated by the QE
program may never be sufficient on their own to
depress the EUR. Other critics wondering why
sovereign debt purchases were not included in
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VOLUME III ISSUE XLVII

THE OPPORTUNE TIME

September 16, 2014

the plan have faced the argument that the ECBs

pay off their debt, or at least enough short-term

buying of sovereign debt would have little effect

confidence to satisfy yield-hungry fixed income

because the yields of European countries are at

investors. And while the ECBs QE plan may

long-term historical lows. However, the critics

provide more time than previously expected for

are right to question the exclusion of sovereign

euro area countries to get their economic houses

debt purchases, for the yield argument is

in order, it remains to be seen if the current

fallacious. The type of debt purchased and

outlined program will be enough. Likewise, even

subsequent effect on the yields of those debt

if increased pressure on the EUR spurs

types is not inherently significant or the primary

inflation, this may not necessarily help with

target of the ECBs actions. It is the money that

Europes unemployment issue that is affecting

will

is

peripheral countries. Because the ECB only has

important, opening up credit and weakening the

an inflation mandate, and given the fact that it

EUR. In fact, investor confidence in the ECBs

took over a year under pressure of deflation

plan would go much farther in lowering

before acting, it is unlikely that the ECB will

European yields and pressuring the EUR than

expand its stimulus program further if inflation

any security purchases would do directly.

increases, even if there is no subsequent drop in

German opposition and the inherent riskiness of

unemployment. And again, it still remains to be

buying European sovereign debt at historically

seen whether its upcoming bond purchases will

low yields was likely influential in the decision

put enough pressure directly on the euro.

to avoid doing so.

However, because of expectations that the ECB

enter

the

economic

system

that

Draghi may be correct in his comments about

the only viable long-term solution to Europes
woes being structural reforms. The current
deflation crisis is not a confidence issue like in
2008 when bank runs were a large possibility,
nor is it a debt crisis like in 2010 when
European countries such as the PIIGS were
perceived to be at risk of default. As mentioned,
interest rates on government bonds across
Europe are at historical lows, indicating a high

would do nothing at all to combat inflation, the

effect on the EUR of its newly announced
attempt at increasing the money supply has
already been felt. Even if barriers prevent the
programs effectiveness, future expansion, or
prolong its timeline, expectations were just low
enough that perhaps even this small step toward
stimulus by Draghi will be just enough to get
Europe over its last major economic hurdle.

level of confidence in these countries abilities to

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VOLUME III ISSUE XLVII

THE OPPORTUNE TIME

September 16, 2014

The Battle for Scottish Independence

Rajoy, have been among the largest proponents

Rattles United Kingdom

for the preservation of the union, due to

invested political and economic interests.
With the fate of the United Kingdom (U.K.)
hanging on a tenuous thread, Scotlands
economic future has become one of the most
fiercely contested issues, as Scots decide on
whether to break away from the U.K. or remain
a part of it. Foreign investors are anxious about
Scotlands

"Yes" and "No" voters protest in Glasgow, Scotland over

the impending Scottish independence referendum on
September 18. Scotland will decide whether or not to end
the 307-year-old union with England. | Photo courtesy of
Getty Images

future,

and

the

polarized

environment has led to increased volatility in

the financial markets.
Scotlands currency is a primary point of

After three centuries, Scotland and England are

on the verge of an historic separation, as
Scotland prepares to vote for independence on
September 18s referendum. Currently, opinion
polls suggest contradictory feelings, and both
sides claim they are poised to win. Scottish First
Minister Alex Salmond, the leader of the proindependence movement, and Alistair Darling,
the former U.K. Chancellor of the Exchequer
who fronts the Better Together campaign, have
been reprising arguments over the economy and
politics in an effort to appeal to undecided
voters in the final days before the vote. The
separatist movement has stirred the Western
world, and several leaders, including President
Barack Obama, English Prime Minister David
Cameron, and Spanish Prime Minister Mariano

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contention that has riled Scots and European

leaders. Should Scotland become independent,
it would retain the British pound sterling (GBP)
until March 2016. Past that date, London has
explicitly dismissed a currency union. At that
point, Scotland has a couple of options. First, it
could keep the GBP as the primary currency,
which Salmond advocates, and, if need be,
without British permission. In that case,
however, Scotland would have not have a
central bank and thus, would not be in a
position to print additional money. If Scotland
joins the European Union (E.U.), adopting the
EUR as its form of currency would be a
condition for membership. Overall, though,
Scotlands inability to continue using the GBP
could have large financial ramifications not only
on Scotlands economy, but also Europe.
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VOLUME III ISSUE XLVII

THE OPPORTUNE TIME

September 16, 2014

Among other financial considerations include a

loss of risk-sharing mechanisms between an
independent Scotland and the rest of the U.K.,
uncertainty about the U.K.s national debt, and
debate over North Sea oil decommissioning
costs. Due to overall economic uncertainties,
Scotlands two biggest banksLloyds Banking
One of the hotly contested topics in the movement for
Scottish independence revolves around Scotland's currency. Uncertainty over the currency could entail massive economic ramifications throughout Europe. | Photo courtesy
of Getty Images

Group (LLOY) and Royal Bank of Scotland

Group (RBS)have joined the growing chorus
of businesses warning about the economic
instability that the breakup of the U.K.s union

Although Scotland already prints its own

could incur. LLOY and RBS have publicly

Scottish pound that is firmly aligned with the

announced

GBP, depending solely on the Scottish pound

headquarters to England in the event of a split.

would have an inevitable impact on the stock

If Scotlands biggest banks leave the country,

market

there could be repercussions on both jobs and

and

potentially

foster

currency

fluctuations. In particular, concerns revolve

around the impact of Scottish independence on
the GBP, which investors are selling off due to
financial uncertainty. Risk premiums on interest
rates would increase and could entail the
creation of a new, central bank. As it is,
Scotlands financial security lies largely with the
Bank of England (BoE), which would no longer
act as lender of last resort. Government officials
would have to decide how to regulate or bail out
Scotlands sizeable financial services industry in
a crisis. Given that Scotlands gross domestic
product (GDP) is roughly one tenth of that of
the rest of the U.K., the majority of the
economic effects of the split would be felt in
Scotland.
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that

they

will

move

their

future tax revenuesa crucial consideration.

The stage for independence is also fraught with
political uncertainty, particularly with regard to
Scotlands inclusion in the E.U. and the
secessions effect on defense policy and other
secessionist movements throughout Europe. As
matters currently stand, it is unclear how
Scotland would make the transition from being
a region of a member state (the U.K.), to a
member state in its own right. Scottish
representatives from the European Parliament
have staunchly announced that Scotland is a
European country and does not intend to leave
the E.U. Nonetheless, because there is no
precedent, Scotlands role in the E.U. will likely

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VOLUME III ISSUE XLVII

THE OPPORTUNE TIME

September 16, 2014

fuel further debate, in the event that it secedes.

have a modestly-sized military force that would

In addition, the referendum will undoubtedly

largely operate within international alliances,

inspire similar secessionist movements in other

including NATO, and play a full part in

countries.

contributing to common security.

Catalan

separatists

and

pro-

The most

independence Basques in northern Spain have

contested defense point, though, pertains to the

increased their protests across Spain, and

U.K.s Trident nuclear submarine base, which

Flemish individuals in Belgium continue to

currently resides in Scotland. Defense analysts

demand more autonomy or union with the

have argued that removing the nuclear base

Netherlands. With regard to defense policy,

from an independent Scotland could destabilize

Salmond has announced that Scotland would

the U.K.s nuclear defense posture.

It is a tight race between the yes and no
campaigns, one fueled by conflicting feelings of
strong nationalism and a sense of shared
identity with England. Hovering over the
polarized camps is the threat of economic
uncertainty that could come with independence,
as concerns over the currency, central bank,
defense policy, and job security comprise the
forefront of the debate. With the end of the
campaign trail in sight, Scottish voters will
ultimately have to decide for themselves the
benefits and potential risks of an independent
state.

Contributors: Andrew Vazquez &

Veronica Aorve

Better Together leader Alistair Darling (above left) and

First Minister Alex Salmond (above right) have claimed
their campaigns could win the vote. They are targeting
undecided voters in the last leg of the close race. | Photo
courtesy of News Letter
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VOLUME III ISSUE XLVII

THE OPPORTUNE TIME

September 16, 2014

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