Speculation in the media had been building for weeks concerning the adoption of quantitative easing – the purchase of sovereign bonds or other financial securities using central bank money – by the European Central Bank. In the run-up to today’s decision, commentators and policymakers had been reaching for the superlatives. Unprecedented action. Opening the monetary floodgates. Last chance to save the euro. Bail out of governments unwilling to reform. Massive risk to taxpayers. Unheard-of mixing of monetary and fiscal policy.
Now the decision is out and it confirms the banality of the step that has been taken, despite all the hype. A banality that, more fundamentally, applies irrespective of the precise details of the measures adopted by the ECB at today’s Council meeting. The “dramatic news” is that the ECB has taken steps today to try to fulfil its mandate to ensure price stability. It is the latest in a series of such efforts. In implementing a QE programme it has, belatedly, decided to act like a normal central bank.
Let’s start with today’s announcement, examine why it is no big deal, and then consider whether it will meet the hope of QE’s proponents or make real the nightmares of its detractors.
What the ECB has decided
The ECB will engage in a QE programme similar to that of the Federal Reserve. It will buy €60bn of public and private sector assets a month until September 2016. The programme may be continued for longer if necessary to get inflation back on track.
The purchases will be of sovereign bonds and investment rated corporate bonds, with some special conditions to be imposed on the bonds of countries under reform programmes (notably Greece). The ratio of national bonds purchased will be in line with the ECB’s capital key (which broadly means in line with GDP weights).
There will be a risk-sharing mechanism under which 80% of any losses incurred by the euro system on bond purchases will be borne by national central banks. 20% of any losses will be shared (again using the capital key). This means that, for instance, if Italy were to completely default on all the Italian bonds bought by the Italian central bank on behalf of the euro system, then the Italian central bank would “suffer” 80% of the losses – on which more below – while the remaining 20% would be shared between the other national central banks.
ECB President Draghi also announced that the bonds purchased by the central banks would not take precedence over those held by private sector actors in case of restructuring or default (pari passu).
In addition there was a minor (0.1pp) cut in the interest rate charged on targeted long-term refinancing operations (TLTROs), in which the ECB makes central bank money available to the banks in return for various lending commitments.
Why this is, or should be, business as usual
In recent weeks markets had largely anticipated the announcement. The euro had weakened substantially, while euro area stocks had risen, bond yields had fallen and also emerging markets had received a boost, as investors anticipated a “reach for yield”. Immediately after the announcement these trends were given a further boost – we will see for how long – indicating that the details of the measures had somewhat exceeded market perceptions.
The programme amounts to around one trillion euros (18 X 60bn), compared to market speculation of an initial decision for one year’s worth of monthly purchases of €50bn. Worries that ECB-held bonds might not be “parri passu” did not materialise. There had been concern about a perceived weakening QE by insisting that national central banks buy their own government’s debt, and take any losses that might be incurred. And the announcement makes clear that this principle will indeed apply to 80% of sovereign purchases. Clearly this is an attempt to placate the Bundesbank and German opinion more generally. The implications of this have been controversially debated. In fact this is almost certainly a storm in a teacup. The risk of paper losses is not large, and if a major default were to occur there would be much more serious concerns than which institution bears such paper losses.
In any case, it is important not to let details obscure the big picture. What the ECB has embarked upon is the same policy already deployed, much earlier in the crisis, by other leading central banks. These countries are in a much more favourable situation than the euro area, a fact that is neither solely due to the difference in monetary policy, nor is it likely to have nothing to do with it. Having reduced interest rates to zero, quantitative easing in some form is a necessary measure in order for the Bank to meet its Treaty-based obligation to ensure “price stability” (ie. inflation close to but below 2%). Even the Bundesbank agrees that it is legal (just not that it is necessary at the present), as does the Advocate General of the European Court of Justice, and almost certainly the ECJ itself.
What now for the euro area economy?
The big question – you can call it the one trillion euro question – is whether this will be enough to turn the euro area economy around, end the deflationary risk and the threat of break-up, and permit a rapid return to prosperity and full employment. I will provide a more detailed assessment, and an alternative proposal shortly. For the time being and briefly:
It is not entirely inconceivable that a combination of lower oil prices, currency devaluation, a more neutral fiscal stance plus any additional impact, via the various indirect channels, of the QE programme the euro area economy might be jolted out of its current doldrums. The risk of a renewed slide into crisis would be averted. Somewhat higher growth, real and nominal, would gradually unwind balance sheet constraints and a slow period of recovery might set in, with unemployment declining slowly. The QE programme will certainly help. Under current circumstances it is – contrary to the lament in some quarters, especially from Germany – essentially a no regret policy. It is a further step in a chain of decisions that were basically correct but “too little and too late”.
There are major reasons to be sceptical, however. The IMF had already factored in these influences (although probably a less ambitious QE programme) and has actually just revised its forecasts for the euro area down somewhat. The programme comes at a time when interest rates are already very low. The euro has already depreciated substantially and, with the euro area already running a current account surplus of around 4% of GDP, it must be doubtful whether a substantial and sustained further impulse can come via net exports. Differences in housing markets and corporate finance may make QE less effective in the euro area than the US or UK. And there are substantial worries about the distributional impacts of asset purchases and relying on a growth model based on inflating asset prices.
It would be foolish to think we have reached the end of the road and polcymakers would be well-advised to consider more direct measures to raise spending in the euro area economy and put growth on a more sustainable footing.