23 January 2015
The European Central Bank (ECB) has announced an extensive quantitative easing (QE) scheme. The size of the scheme will be much bigger than anticipated with the ECB using its own newly-created money to buy €60bn of government bonds each month from across the Eurozone. This €1.1tr (€1,100bn) scheme will last until at least September 2016, and ECB President Mario Draghi has offered to extend it if inflation in the Eurozone does not rise back to the ECB target of 2%.
The ECB’s announcement follows the operation of very similar schemes by the US, Japanese, and British central banks over the last five or six years. The Bank of England’s own QE scheme has seen it buy up £375bn of British government debt since it was launched in 2009. QE’s supporters say that it has helped support banking systems on the brink of collapse boosting lending where it has been tried – and can now point to seemingly healthy growth in the US and UK as further evidence of its success.
The threat of deflation
The ECB has introduced QE under the threat of deflation, as suggested in last week’s blog. Deflation – persistently falling prices – is a calamity for a monetary economy:
• It reinforces a slump in spending: households look to hold off on their own spending –why buy today, if you know prices will be lower tomorrow? • Companies ease off on their investments: they know that whatever they produce in the future with the investment today will be sold at a lower price. Why invest today if you know your profits are going to be squeezed? • The second-round impact of falling prices: as prices fall, so does demand and companies look to cut their own spending. Companies cut overheads like wages, so suppliers and workers see a fall in the amount they earn. Companies still have to pay debts – as their income falls, more of their money has to go towards debt repayment. In turn, there is less spending in the real economy, reinforcing the slump. So the bigger the debts, the worse the decline. And Europe has big debts.
Deflation is a rarity in modern times. While Japan has suffered bouts since the 1990s, prices have not consistently fallen in Europe since the 1930s. With that ominous date in mind, headline inflation rates of ‑0.2% across the Eurozone have compelled the ECB to act today.
The thinking behind QE varies. Currently, there’s not mainstream consensus as to how QE works, or what its real impact is. The original idea was that by getting a load of freshly-created, high-quality central bank money into the private banking system, banks will start to feel more confident about their own lending. As they feel more confident, they make more loans, and as they make more loans, the economy starts to pick up. It’s not quite the same as printing money, since although the central banks use their power to create new cash to make the bond purchases, they are actually buying the assets – or so the central banks will claim.
Until a few years ago, this was considered the main impact of QE. However, the last few years show that this “lending channel” from QE to the real economy, doesn’t appear to be the main impact of the process. One way or another, QE should set a floor to falling prices: you’d anticipate that a great flood of high-powered money, with a promise of open-ended money creation until the inflation target is met, should lead to rising expectations of inflation and therefore (over time) actually rising inflation. That should help sustain a generalized recovery, which more optimistic souls are tentatively suggesting is just beginning in the Eurozone, were it not threatened by deflation.
However, uncertainty over the impact of QE leads us to suspect that the ECB’s QE scheme may not break the crisis in the Eurozone, for three reasons:
1) The transmission mechanism
As above, the “transmission mechanism” from the central bank’s bond-buying into the rest of the economy is not entirely clear. For the US, the most obvious impact of QE has been on share prices. Companies there have been gorging on cheap loans, borrowing $1tr ($1,000bn) over the last year. But they’ve not been using this money to invest. US corporate investment is close to an all-time low.
Instead, they seem to be using money to buy back their own shares.Corporate buybacks, in which a company buys back its shares from shareholders, hit record levels last year, with $555bn spent to October alone. This is good for:
• Shareholders (bearing in mind, the top 1% own 35% of US shares, the bottom 90% just 19%) • Investment banks arranging the buybacks, since they take a cut • Company directors many of whom have incentive schemes tied to the price of their shares
But the advantage for the economy in general is a little less clear. And with US corporate borrowing growing at twice the rate of US corporate sales, it’s unlikely this situation can be sustained.
The UK seems to have a different transmission mechanism. Here, much of the impact has fed into rising asset prices, including property, rather than increased investment and therefore spending by companies. The Bank of England’s own assessment notes confirm we’ve seen an increase in asset prices and, as in the US, the ownership of assets is concentrated – so we’ve ended up inflating the wealth of the wealthiest. The Bank of England estimates that 5% of households in the UK own 40% of the assets most affected by QE – so the prices of central London mansions have soared since 2009, even as real wages continued to decline.
For the Eurozone, the transmission mechanism is even more opaque. While the euro members all use the same currency, the crisis has shown that different economies with different financial institutions face different problems. Even something as simple as inflation rates vary substantially. Prices in Portugal have fallen by 0.4%, Spain down by 1.1% and by 2.6% in Greece. But Germany has seen 0.2% price increases over the last year, and Netherlands 0.7%. There’s no guarantee that a one-size-fits-all monetary policy can be made to work.
Another immediate, intended impact for QE is to hammer down longer-term interest rates. By buying up government bonds on a huge scale, the central bank undertaking QE pushes up their price. Because the interest rate on a government bond is the inverse of its price, borrowing costs should fall. But for most Eurozone members, borrowing costs are already at rock bottom. There’s not very much else they can do here.
2) The danger of failing to share risk
The Eurozone consists of many different economies, and the risks associated with borrowing vary between each one – that’s why the interest rate can vary so much. For example, lending the German government money is seen as less risky than lending to the Greeks. The monetary union is supposed to disguise this unevenness, in the sense that everyone uses the same currency controlled by the same central bank.
However, the European Central Bank does not rest on a single state; it is supported jointly by all the euro members. Should the ECB take on more risk – for example, by buying up high-risk government bonds, like Greece’s – then it is at more risk of collapse. But the burden of that additional risk will not be spread evenly across the Eurozone. It will, in practice, be borne by its strongest members – meaning in practice, mostly by Germany. However the German government is opposed to taking on the risk of a collapse elsewhere in the Eurozone.
But for QE to work, the ECB has to take on extra risk by buying up Eurozone members’ bonds. As a result, the QE proposal contains a compromise that contains the seeds of the eurozone’s unwinding.
It’s been agreed that most of the risk of the assets bought under the scheme will lie with each euro members’ own central banks. While they still function in the euro, they act as a subsidiary of the ECB for each member state. So 80% of the bonds bought will sit on national central banks’ balance sheets, with just 20% subject to “risk-sharing” through the ECB.
What this means for the Euro
This seems innocuous enough. But the entire point of the euro is that it is a single currency, subject to a single monetary policy and with risk-sharing across the whole Eurozone. In the euro’s glory years, this single rule and joint sharing of risk seemed to hold. Interest rate differences between, say, Germany and Greece was minimal, as those trading bonds believed that risks would be spread out, and the ECB could never allow a member to default or leave the euro. That assumption was blown apart in October 2009, as the Greek debt crisis erupted. Since then the interest rates have varied substantially.
The specific risks in this version of QE emerge in the difference between the ECB and each member state’s central bank. The ECB can issue its currency and therefore cannot end up insolvent. But national central banks do not have that power – they rely, like conventional private banks, on the support of the central bank. In theory, they therefore can collapse and would need bailing out. So there is a risk attached to national central banks holding their government’s debt, particularly where that debt is very risky – like Greece, for example.
What we see in the ECB’s QE is an institutionalization of the underlying reality that the Eurozone consists of separate national economies without proper risk-sharing. It means the ECB has conceded the euro does not function as an effective risk-transfer mechanism, since risks are no longer fully transferred. And, meanwhile, the euro members most in need of QE in southern Europe are going to be the least able to gain its benefits.
The euro’s existence as a single currency has been undermined and the political argument for exit has received a boost. The entire eurocrisis has been, to a large extent, one long effort to pretend it wasn’t really there – and that the fundamental problem posed by 19 different countries all trying to use one single currency really had been solved. But if you wanted to see a quicker route towards a euro break-up, the QE package presented today would be a good one to follow. Draghi’s 2012 promise to do “all it takes” to save the euro, which calmed market fever at the time, now looks hollow. He’ll do 20% of what it takes.
3) How does it all end?
Let’s assume that the QE package works. The euro holds together, deflation is seen off, and the signs of recovery that some have pointed to become promising. In a few years’ time, we’re all back to happy pre-2008 times. It’s time to end the QE programme and to sell the bonds back to the market, as expected. This has to happen, it is assumed, or else QE really will have been little more than a money-printing exercise to write off debt. The whole exercise would have been a sham. So you have to “unwind” QE.
But selling these bonds will push down their price and therefore push up interest rates. One estimate puts the cost to the Federal Reserve of unwinding its last QE intervention at over $500bn. We saw last year how even the threat of easing off on the current US QE programme provoked market panic, particularly across middle-income countries. No-one knows how to unwind a QE programme successfully, since no-one has done it before.
And hanging over it all is the prospect of a beggar-thy-neighbour race to devalue currencies. The currency in every economy where QE has been implemented has fallen in value against others – and the euro is no exception, falling to its lowest value in years after yesterday’s announcement. (The reason being that more euros in circulation mean their value, relative to other currencies, falls in trading.)
This is good news for exporters in the Eurozone, meaning cheaper exports and boosting demand. However, everyone else will face increased competition from newly-devalued euro exports. They may also be tempted to attempt competitive devaluations, meaning everyone competes to make their goods cheaper and cheaper. A desperate race to the bottom can set in (and may already be in train), matching what arguably happened in the 1930s as the Gold Standard collapsed.
A possible solution
The answer might be exactly as Syriza, likely victors in Sunday’s Greek elections suggest: to admit the inevitable need to write off debt. Combine this with what NEF has previously called strategic QE, and what Yannis Varoufakis, one of Syriza’s leading economists, has called for: instead of using QE money to buy up government bonds, get the cash directly into the real economy.
The ECB could buy up bonds from the European Investment Bank (EIB), and the EIB could go out and invest directly in infrastructure, boosting demand and creating tens of thousands of jobs – a veritable New Deal for Europe. The ECB won’t do this without exceptional pressure being applied; it’s taken this long to get the agreement we have, principally because of opposition from the German government. There is a decided lack of enthusiasm for weakening the strict dividing line between monetary and fiscal policy that strategic QE implies.
Debt write-off remains more likely. It’ll hurt the banks, and it’ll hurt the European institutions that now carry Greek debt. But the cost of the endless pretense that debts can be sustained, and the euro continue in its current form, is now looking like permanent stagnation.
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