Myths and Realities of European QE

The effects of the ECB’s quantitative easing are still unclear and may be insufficient to drag economies out of low growth and high unemployment rates. In effect, removing market pressures might affect incentives to pursue the structural reforms that Europe needs, such as completing the single market and restructuring banks and corporates.

There is nothing left of a ‘conventional’ nature in the action plans of central banks around the world. The European Central Bank (ECB) has begun to buy securities, and in particular government bonds, within its quantitative easing (QE) operations. The ECB is using the most powerful weapon in its armoury. Europe is now in uncharted waters. This decision comes after three years of less invasive interventions, like the long-term refinancing operations at a very low interest rate or negative yields on excess liquidity at the ECB. Although these interventions have avoided a financial catastrophe in the euro area, these measures have not addressed the underlying causes of negative inflation and lack of access to credit mostly in the periphery (financial fragmentation). On the contrary, the banking system has been weakening and has become less international, as banks propped up their balance sheets with domestic government bonds to exploit the implicit guarantees of governments and to benefit from a carry trade between the ECB rate and market rates. This is not what the ECB wanted, i.e. to restart access to credit for the economy through direct liquidity provision to banks.

The nature of this intervention

As for other central banks’ interventions, the loss of control over the traditional mechanisms for the transmission of monetary policies to the financial system is at the very heart of this massive credit expansion via outright purchases of securities in secondary markets. The direct intervention in secondary markets to buy low risk securities (including securitised products and covered bonds) is very close to a last resort action. Although amounts are not as big as a central bank (like the ECB) could go, the ECB can now buy each month €45 billion of Euro area government bonds and €6 billion of securities issued by European institutions, such as the European Stability Mechanism (ESM). Monthly purchases will take place until September 2016, but with the possibility to extend them further if the inflation rate does not move closer to 2%. However, some additional restrictions apply. The ECB cannot buy more than 33% of the outstanding value from the same issuer, nor can buy more than 25% of a single issuance. Still a big number, though.

Furthermore, only 8% of the purchased government bonds will be consolidated in the ECB balance sheet, while the rest will be taken up by national central banks at their own risk. Risk sharing, however, may be just a fiction, since central banks can operate even with negative net capital.

What are the effects on the broader economy? 

There are no doubts that this is the most important (and symbolic) action that the ECB has undertaken during its brief history. Whether it will produce bigger effects than other initiatives (e.g. LTRO) on the economy is a different story. Yet, the European QE is a partial monetisation (and so mutualisation) of public debts in the Euro area. An unprecedented decision that was unimaginable even a couple of years ago. Most importantly, the decision to use 12% of the firepower to buy securities issued by EU institutions, such as the ESM, makes unofficially the ESM a prehistoric species of European treasury.

The main effects of the European quantitative easing can be classified in three areas: interest rates and monetary base, exchange rates and fiscal policies.

–          Effects on interest rates and monetary base

Similar initiatives to the European QE have had a very good success in the United States, but the environment was a different one. As today, the interest rate curve in the Euro area is already at historical lows, even on the long-term side of it. Government bonds spreads between core and periphery have quickly gone down to before 2010 levels. Italian and Spanish 10 years government bond yields are below 2%, while Germany is enjoying ridiculous negative interest rates on short and medium-term maturities.

Figure 1. 10-year ECB Benchmark Government Bond

Source: ECB.

It is unclear how long this situation will continue, but some people argue that the announcement effects of the ECB QE has already led to a decoupling of interest rates between Greece and other peripheral countries. However, it may be seemingly true that decoupling has been taking place since some time, and in particular when the Greek debt was gradually transferred in the hands of international organisations and European institutions that do not operate under market rules.

Furthermore, many believe that the purchase of securities on secondary markets shall provide banks with additional (needed) liquidity, as they are already facing the repayment of the long-term refinancing operations that have come to maturity. Ultimately, this intervention in theory would push banks to give more credit to the economy. In practice, the story may be different. Thanks to the zero-risk weight, the use of these securities as collateral and risk aversion, i.e. the total opportunity cost of investing in other instruments than government bonds, the massive purchase of government bonds may actually have unintended (opposite) effects on the cost of credit.

–          The effects on exchange rates

The QE announcement has already weakened the euro, which is discounting part of the intervention, and we may soon see the parity with the dollar. It is a strong signal to expand the monetary base in order to revive yields on alternative assets and remove speculation on public debts. In theory, it should also stimulate exports and investments. Nonetheless, only 20% of the Euro area exports go outside the Euro area. The impact on exports may be fairly limited and certainly scattered across the different member states. Meanwhile, we already see the first victims of capital outflows from the Eurozone. The Swiss central bank has given up the parity with the euro, while the Danish government has put on hold issuance of government bonds. It is difficult to say what will be the long-term impact on the sterling and more generally on the UK economy, which still has to deal with its real estate bubble. In addition, some public debts (like France) is predominantly in the hands of foreign investors and it is difficult to say if the ECB will be able to offset potential outflows. Nevertheless, the Euro area shall not underestimate the instability surrounding a weak euro currency, in particular if the continent cannot offset this trend with a strong political influence on the global governance (like the United States).

–          The effects on fiscal policies (incentives)

QE shall improve the external financial position of the Euro area. However, the balance of payment (even for countries in fiscal troubles) is positive or close to zero. On average, the euro area is creditor towards the rest of the world. QE would have had a greater impact in the midst of the financial crisis post Greek debt restructuring,[1] with a negative balance of payment and soaring government bond yields. Risk of inflation was negligible at that time.[2]

We should also ask ourselves whether racking up government bonds from banks balance sheet will automatically encourage governments to restructure banks, as well as corporates, through the completion of the single market and greater mobility of inputs throughout the Euro area. Is consolidation and mobility at European level a priority for national fiscal policies? Are incentives aligned even without market pressures? Is there a European project behind national structural reforms, as a counterpart to the ECB QE? Ignoring the link between monetary and fiscal policies will only prolong uncertainty and be a drag on the European economy. The ECB thus ‘buys’ time for a price that may be very high and with the big uncertainty about who will ultimately pick up the bill.

[1] As some argued at that time, including myself. Valiante, D. (2011), “The Eurozone Debt Crisis: From its origins to a way forward”, Center for European Policy Studies, Policy Brief, n. 251.

[2] The yearly inflation rate (HICP) today is more or less at the same level than 2009 (source Eurostat). It was at that time clear that the crisis would have continued for a while and the rise of inflation rates in 2011 was a temporary ‘bouncing’ effect. The ECB shall also consider in its assessment the forward component of the inflation rate and not just historical rates.