Benchmarking the ECB’s QE Program

Yves here. The ECB is set to announce the details of its QE program tomorrow. Many analysts and investors have been trying to puzzle out how its operations might work, since those details will make a difference in what impact if any it has.

Frankly, we are hugely skeptical of this initiative. The US version, which is bizarrely touted as a success, further zombified the economy. It goosed asset prices, which widened wealth and income inequality. Now respectable economists are decrying the widening gap between rich and poor and the lack of class mobility as a brake on growth, yet they also refused to endorse debt restructuring and much more aggressive fiscal spending. And some experts contend that the reason the Fed decided to end QE last summer was that it came to recognize the costs outweighed what if anything it produced in the way of benefits. Of course, they can never admit that publicly or even privately if true.

In Europe, there is even more reason to be expect QE to be at best ineffective. Unlike the US, where as a matter of policy, a lot of financing takes place through the capital markets (for instance, credit card debt, subprime auto loans, home loans are all securitized to a large degree), in Europe, far more credit is on bank balance sheets, and small to medium sized corporate lending is far more important than in the US. Thus, while as we have repeatedly explained, putting money on sale is unlikely to result in more borrowing unless the cost of money is the biggest cost of running your business (ie, you are a bank or a speculator), in Europe you have the added layer that reducing investment yields is unlikely to change how credit officers view lending to small/medium sized enterprises (assuming they even want to borrow) in a weak, deflationary economy.

This Bruegel post describes the major options that the ECB has in designing its QE program, which will help readers benchmark tomorrow’s announcement. One might politely describe the choices as bad and less bad.

By Guntram B. Wolff, Director of Bruegel and former member of the European Commission, Marcel Fratzscher, and Michael Hüther, a German economist and director of the Institut der deutschen Wirtschaft. Originally published at Bruegel

The ECB’s Dilemma: German Opposition to Government-Bond Purchases by the European Central Bank is Solidifying Ahead of the Programme’s Likely Announcement

Authors: Guntram B. Wolff, Marcel Fratzscher, Michael Hüther

German opposition to government-bond purchases by the European Central Bank is solidifying ahead of the programme’s likely announcement on January 22. Elections in Greece that could bring a government that will seek to negotiate the country’s debt with official creditors puts the ECB’s decision under even greater scrutiny. The fact that the ECB did not share losses in the previous round of Greek debt restructuring highlights the problem of sovereign QE, which is not feasible or will be ineffective if fiscal implications are excluded. The design of the programme is therefore crucial.

ECB is falling far short of fulfilling its mandate of keeping inflation below but close to 2%

With the euro-area inflation rate at minus 0,2% and an increasing de-anchoring of inflation expectations, the ECB is falling far short of fulfilling its mandate of keeping inflation below but close to 2%. Many German economists and politicians downplay this failure by trying to re-define price stability as an inflation rate above zero. This is wrong for a number of reasons. A third of the sectors in the euro area, including in Germany, is in deflation. Low inflation is harmful because it makes price adjustment harder, undermines investment and renders debt service more difficult.

Monetary policy alone cannot fix all the problems of low growth and low inflation as many Germans rightly point out. Significant structural reforms and investment to stimulate higher demand will pay off rather quickly. A strong commitment to such reforms is essential for exiting the crisis. Nevertheless, the ECB should not and cannot hide behind slow government progress on reform, but should instead fulfill its mandate.

The more and longer that inflation expectations remain unanchored, the harder it will become for the ECB to regain credibility

The reason for the growing German opposition to a sovereign QE programme is the fear that it could result in illicit monetary financing of governments. A QE programme would have to be combined with an implicit understanding that the ECB accepts losses on the same terms as private creditors in case of a debt restructuring. Otherwise, the purchase of low-rated government debt would be largely ineffective and could even lead to an increase in sovereign yields.The ECB has four options.

The first is to wait and hope for the best. This is the preferred strategy of many Germans, but would be dangerous and irresponsible. The more and longer that inflation expectations remain unanchored, the harder it will become for the ECB to regain credibility and achieve price stability, and the higher will be the real economic costs for the euro area and for Germany.

The second option would be to allocate the potential losses from purchases to the individual national central banks in the euro area. This might sound like an attractive option, but would be counter-productive by increasing sovereign spreads and worsening financial fragmentation within the euro area. And it would send a devastating signal that the single monetary policy would be single in name only.

The third option is to focus government bond purchases on highly rated debt only to limit the balance sheet risks to the ECB. This strategy could succeed, but the ECB would have to buy large amounts of already low-yielding, “safer” euro area sovereign debt and hope that private investors subsequently rebalance their portfolios towards riskier euro-area countries.

The fourth option– while accepting that the founding fathers of the euro might not have foreseen that monetary policy has to accept some fiscal risks – would be for the ECB to purchase sovereign debt according to the capital key of individual euro-area countries, with adjustments for those without sufficient amounts of privately held sovereign debt. The Treaty does not prohibit such purchases in secondary bond markets. The ECB’s governing council has expressed its intention to expand the balance sheet by €1 trillion. As this will hardly be possible with private sector assets only, the ECB could buy a portfolio of government debt combined with a portfolio of private debt.

The ECB needs to urgently show its uncompromising determination to fulfil its mandate and repair monetary transmission in the euro area.

The ECB needs to urgently show its uncompromising determination to fulfil its mandate and repair monetary transmission in the euro area. Accepting some fiscal risks is reasonable and unavoidable. The fourth option is the most promising strategy for the ECB to raise inflation expectations credibly and durably, avoid stagnation and help end the debt crisis. It is a risky strategy, but the other strategies are riskier.

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  1. Jim Haygood

    From Draghi’s prepared text:

    ‘Purchases of securities issued by euro area governments and agencies will be based on the Eurosystem NCBs’ shares in the ECB’s capital key. Some additional eligibility criteria will be applied in the case of countries under an EU/IMF adjustment programme.’

    Translation: special rules for Greece [to be announced].

    ‘While the monetary policy measures adopted between June and September last year resulted in a material improvement in terms of financial market prices, this was not the case for the quantitative results.’

    Translation: stocks went up, jobs didn’t. Who coulda knowed?

    What counts, comrades, is competitive devaluation. On that front, the euro is below $1.15, near an 11-year low. Winning!

  2. Rosario

    I’m pretty sure this was inevitable. Central Banks can’t stop boosting liquidity and they sure as hell can’t demand repayment with any meaningful interest on debt issued (creating a sustained, serviceable debt relationship). All critique of the actual “plan” aside, I’m curious who is next to hop on this train. China? India? I’m certain Russia wants nothing to do with this. It seems they are trying to weather the storm.

    This move has me curious why sovereign debt, according to the loudest planners, has to either be zero (Paleoconservative/Austrians) or effectively infinite (nearly everyone else), and in the midst of a completely directionless political-economy without a shred of democratic process (i.e. Central Banks and Treasuries are non-democratic, Technocrat run organizations). Debt is a relationship, too much and one or the other is untrustworthy, too little and the relationship does not exist. Any thoughts? How can citizens maintain a relationship to debt via the state that they have no say in ordering? How does an “expert’s understanding” of economic process have any value when the debt issued in that process has its tender built upon the bedrock of a public trust that is faltering or non-existent (mostly because of the process’ obscurity and narrow range of “public” services provided).

  3. WanderingMind

    Hopefully, someone here can clarify something for me. It is my understanding that the ECB, like the Fed, can create money electronically in unlimited amounts. So, when the ECB starts its 60 billion euro per month purchasing program, the source of funds will be itself. If I am wrong about this, I would appreciate someone correcting me.

    However, if I am right, then what is the risk exposure for the ECB when it purchases bonds or other assets? If all of those assets go to zero in value, the ECB can still create additional euros in unlimited amounts.

    1. Jim Haygood

      You are right. And the risk is simply credibility. In the immortal words of Seth Carpenter:

      ‘One example of a central bank with a form of a deferred asset is the Czech National Bank. This institution has operated for a number of years with a negative equity position and zero remittances.’

      The unbearable lightness of negative equity central banking, as it were. Do not attempt this at home!

      1. WanderingMind

        When you say “credibility,” my next question would be: Credibility with respect to who? Surely if you and I are aware of the operational reality of central banks in this respect then the geniuses at Goldman Sachs, JP Morgan, etc know this as well. So, they know that a central bank can buy all of the assets it wants in the currency which it issues and if a central bank does not do so it is out of choice, not necessity.

        Is it only the “ignorant masses” and politicians that the central banks worry about in terms of credibility?

  4. Irrational

    Well, I am sitting here watching the German evening news after the announcement and all are running specials on the ECB move. Main theme: how interest rates will get even low for thrifty German savers who still keep all the savings in the bank. A few commentators are daring to say that maybe having a job is more important than the interest on your savings and so this is a good move. Of course, nothing to say that supply creates demand in this case!
    Minor peeve: Mr Wollf was certainly not a “member of the European Commission”, since that would imply that he was one of the Commissioners, the very top managers. It would be more correct to say that was a Commission employee/official/civil servant. Sorry to be a bore.

  5. John Yard

    Ms Smith : Isn’t a major thrust of European QE the driving down of the euro vs the dollar via lower interest rates ? If you look at the euro/dollar relationship since 2009, there was a huge spike in 2011 at 1.50 and another spike at 1.40 last May. I think a good case can be made that the euro at 1.40 choked off the nascent recovery the EU was having.
    I don’t have the souce at my fingertips , but the Italian PM this morning stated this morning that he looked forward to a euro/dollar parity – the euro at 1.00.
    If the euro can reach parity with the dollar for an extended period, that is a 30% boost to Europe vis a vis the US ( and a corresponding hit to the US ). Along with lower energy prices , which should impact Europe better than the US because except for Norway and UK Europe imports energy, we could see a short to midterm
    positive impact from these merchantilist policies.

  6. ewmayer

    “A few commentators are daring to say that maybe having a job is more important than the interest on your savings…”
    And if you’re retired? Also, the pompous “having a job” angle ignores the asset-mispricing/misallocating and bubble-promoting aspects of ZIRP and QE. Deliberately, because it’s by now more than clear that in the major developed-world nations and regions – a characterization that appears to align almost perfectly with ‘debt-expansion-based economies’ – the central banks have just one tool in their toolbox, that of attempting to blow ever-larger speculative bubbles. The excuses vary from ‘fighting deflation’ (which is the natural flip-side of any bubble, a fact the bubbleheads invariably ignore) to ‘promoting groaf’, but the attempts always boil down to one ‘true mandate’: promoting bubbles, and vainly hoping that the latest one will both ‘trickle down’ and ‘stick’.

    Anyhoo, the only “deflation” this latest round of printing has a hope of curing is the “looming deflation in the CB-backed bubble-priced risk assets of the financial elites.” At some point one of these Ctrl-P initiatives will fail to goose the so-called markets – when that happens, watch out below.

  7. RBHoughton

    Good analysis in my opinion. This QE decision simply reveals Europe’s inferior status in the world these days.

    They knew what they should do but were willingly pushed into the wrong decision in spite of the deleterious effect it will have on Europeans.

    There was a chance for Europe to have been the world’s arbiter of economic systems, sitting between the AngloAmericans and the BRICS but no, EC politicians would rather pay the banks to stop harrassing them. Tragic political cowardice, bordering on treason for the captive population.

  8. Goldcap

    A balanced application of QE (via sovereign banks, which is what this is, right?) makes no sense. Why would QE in Germany work identically to QE in Italy or France, Spain or Greece? If anything, shouldn’t bond purchases focus on the economies that are overburdened with large debt/gdp ratios? (And, IMHO, ridiculous austerity.) We should be talking about debt restructuring, not QE, no?

    It’s the strangely obvious disconnect between Draghi’s monetary policy and any realistic palliative fiscal policy that makes me wonder if this isn’t some twisted EU moral crusade against “lazy” southern EU members.

  9. James Tennier

    In my opinion, QE in the U.S. these past few years has been nothing more than crediting wall street with enormous sums to play/ gamble with as they chose.
    Doing this in the EU will have the same effect wouldn’t one think?
    Why use the same standards for such different economies as Germany v. Greece to do little more than hasten the day Greece defaults thereby prompting all those insurance payments to the likes of GoldmanSucks?

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