Will quantitative easing in the eurozone continue the era of cheap money?
- 4 April 2014
- From the section Business
European Central Bank (ECB) president Mario Draghi has opened the door to large-scale cash injections in the eurozone.
Quantitative easing (QE) had always been thought as beyond the ECB's mandate.
But, Mr Draghi said that QE and other "unconventional instruments" were discussed and the entire 24-member board, which includes the German Bundesbank, was "unanimous" in its commitment to deploy such instruments if necessary.
So, what's changed?
The fear of deflation, or prices falling, mainly.
Price rises in the eurozone have slowed to just 0.5% from a year ago. Such low inflation hadn't been seen since the global financial crisis when the economy was in recession.
Now, even though crisis-stricken economies in the eurozone are recovering, the repayment of debt plus stagnant demand are putting downward pressure on prices.
It's not uncommon after a debt bubble bursts.
Japan is a case in point where it's only after 20 years that deflation is easing, helped by extraordinary cash injections.
However, with interest rates at a record low 0.25% already, there isn't a great deal of manoeuvre there.
Even if the so-called deposit rate, currently at 0%, was cut even further so that commercial banks pay the ECB to park their money, the impact on cash in the economy is likely to be minimal. Denmark tried negative deposit rates before as a case in point.
What are the ECB's options?
One of the ECB's dilemmas is that most central banks undertake QE by buying their own government's bonds. So, the Bank of Japan buys Japanese government bonds, the Bank of England buys UK gilts, and the Fed buys US Treasuries.
But the ECB has many governments that it serves - 18 in fact. So, whose bonds does it buy?
If it selectively buys say Spanish bonds, say, then it could be accused of financing governments which the ECB has said repeatedly that it cannot do.
The only way that it would do that is if a country is suffering from "severe distortions" in the bond markets and is essentially in a rescue programme being supervised by the European rescue funds (EFSF/ESM) and the International Monetary Fund. The OMT, Outright Monetary Transactions, was enough to reassure markets for a while that the ECB was ready to act if needed. But, there was a lack of detail on how it worked and no country wants to be in a programme so that limited its impact and the OMT was never used.
However, the ECB has injected cash in a more roundabout way before.
A few times, it has offered unlimited cheap cash for banks to borrow.
The long-term refinancing operations (LTRO) ended up injecting over a trillion euros of cash into the eurozone economy.
The problem is that by going through the banks, the money didn't make it out into the real economy as banks used it to shore up their own balance sheets. It was of course the aim of the LTRO and other such programmes to support liquidity in banks, but with the hope that lending could pick up.
But, commercial loans are tepid and cash isn't circulating which contributes to the disinflationary environment.
Picking and choosing
So, coming back to injecting cash directly, the question is whose bonds does the ECB buy?
There's a proposal by Harvard professor Martin Feldstein which calls for the ECB to buy a GDP-weighted basket of bonds, so that it can basically buy a mix of bonds based on the size of the respective countries' economies.
Germany and France contribute half of total eurozone GDP. Along with Italy and Spain, these four countries make up three-quarters of the economy of the eurozone.
Thus, under the proposal, the ECB would buy mostly their bonds and those of the rest of the eurozone according to their economic weight.
That could limit the distortionary impact of the ECB selectively buying in the bond market and therefore treading on its mandate to not finance specific governments.
Also, given the large weight of Germany and France, the risk to the ECB balance sheet would be less and not too remarkably different from other central banks. Italian and Spanish bond yields have dropped, with 5 year borrowing cost at record lows. Besides, even the bond yields or borrowing costs of peripheral European countries have begun to come down considerably.
In addition to the euro crisis easing, one of the reasons for the drop in borrowing costs is deflation. Lenders require lower nominal returns if inflation isn't much of an issue. The real return on bonds (government debt) is the difference between nominal returns (bond yield or the borrowing cost for governments) and inflation. If there's high inflation, it makes the money that they earn worth less when it is repaid in the future so they want a higher yield. If there's deflation, then the reverse is true.
So, deflation risk has changed the context.
If the ECB were to act now, it wouldn't be seen as helping a country that bond markets were selling off. It would be viewed as trying to get the economy going and preventing deflation and prolonged stagnation.
In that sense, the ECB could find it easier to do some variety of QE. But, there will be many more discussions over its mandate, I suspect.
If they do act, then the era of cheap money that had seemed to be coming to an end with the Fed tapering could be prolonged.