2014 highlighted the ongoing fragility of the eurozone, which continues to fight the economic illness that contaminated Europe five years previous.
Since then, much has been done to repair and strengthen the conformation of the eurozone. Ranging from the establishment of a bail-out fund and creation of a banking union, to Draghi’s pledge in July 2012 to “do whatever it takes”, it was clear that Europe’s leader has shown determination to remedy the region’s ills.
However, recent developments in Greece, the downgrading of Italy’s sovereign rating (to BBB-) and low inflation have caused concerns amongst speculators. Pressure is once more on the European Central Bank (ECB) to provide a panacea for this illness.
Benoît Coeuré, a member of the ECB’s Executive Board, recently said that a more expansionary monetary policy in the eurozone was “a legal and moral obligation” given its mandate. Yet, if Quantitative Easing (QE) is indeed a moral and legal obligation for the eurozone, is it also a panacea for economic health? We doubt it.
Indeed, the drop in oil prices and probable drop in inflation have left markets unsettled and the ECB with little choice. It already started down the path of QE in late 2014 by buying private-sector assets. But neither covered bonds nor asset-backed securities are large enough purchases to have much impact. Another form of private asset that the bank could purchase is corporate bonds, but the ECB would still be hard-pressed to buy more than around €100 billion a year, leaving it a long way from its goal.
So, that leaves the purchasing of sovereign debt. When a central bank buys government bonds in exchange for monetary creation, it can do it either because it is the most effective way to increase the quantity of money, or to improve governments’ fiscal solvency by monetising public debt. When a central bank holds a government bond, the interest paid on this part of the public debt disappears (it is paid by the government to the central bank then paid by the central bank back to the government), which is therefore equivalent to a cancellation of the public debt bought by the central bank.
Given the eurozone’s high level of public debt – even more apparent if we exclude Germany – the idea that the eurozone’s public debt should be monetised is a fair one. But it would be shocking if that was done in a disguised form, under the appearance of a quantitative monetary policy operation – which would subsequently create major tensions with Germany. Indeed, the credit ratings of the countries in the euro area vary from ‘AAA’ in Germany to junk in Greece. Buying Greek debt would expose the central bank to potential losses if Greek politics sour further.
Without conditionality and without making any demands on the governments, the ECB’s decision would therefore be controversial.
QE as a remedy to Europe’s economic woes?
That said, the markets have already factored in QE to combat low inflation, and the failure to implement the policy could result in fatal consequences for the eurozone and the single currency.
So, the ECB must succumb to the expectations of the financial markets. QE will be implemented at a time when asset prices are high, interest rates are low, and the banks have no need for additional liquidity – as shown by their limited use of the Targeted Longer Term Refinancing Operation (TLTRO).
Pumping more liquidity in to the eurozone will lead to absurd financial asset prices, as well as negative interest rates, and the squeezing of risk premia. Moreover, the effectiveness of QE is being reduced in the eurozone by continuing private sector deleveraging, which has rendered the bank credit channel of monetary policy totally ineffective. And despite the rise in asset prices, the absence of wealth effects will mean that households in the eurozone will fail to consume more and save less. The only positive effect of the ECB’s quantitative easing may be a depreciation of the euro.
But will the ECB analyse these drawbacks when faced with the obligation of its mandate?
And if it goes ahead, which is more than likely, does QE even have the power to drag the euro area out of its state of sluggish growth and low inflation?
Putting these questions aside, the core point remains; if the ECB decides not to implement QE, the financial markets could collapse. There will be a rise in interest rates, a fall in the stock market, a widening of credit spreads and the euro will start appreciating again.
Indeed, the ECB is a prisoner of financial markets’ expectations.
