Recent comments from the ECB about potential attempts to mitigate a decrease in inflation through QE have led to an increased interest in the articles posted on this website about the SMP and the CBPP. However, such interventions were pursued for different purposes and as such may offer only partial insight into what the ECB may do. I take this opportunity to briefly review some of the alternatives available to the ECB. I also offer a belated apology and explanation for the decreased posting over the last six months, for those interested.
As mentioned in the ever-delayed updates to the chronology of the Euro-Zone crisis, Mario Draghi was keen to reinforce the ECB’s Governing Council discussions of the use of unconventional policy tools to attempt to mititgate the downward (potentially deflationary) trend of deflation at the last meeting of the central bank. This has rightly been interpreted as a sign of the ECB’s willingness to engage in QE. The question of course is how such an intervention would be implemented.
What is QE?
Quantitative Easing (QE) as has been conducted by the BoE, the Fed and the BoJ is understood to be a stimulus to the economy brought about by an artificial decrease in interest rates caused by large purchases of government bonds by the central bank. In this sense it differs from SMP and operation twist to the extent that it actually creates more money. The idea is to make money cheaper to decrease the cost of borrowing and increase consumption or investment. In the USA, QE has taken the form of purchases of treasuries and MBS, the idea being to lower the benchmark interest rates and to decrease the cost of mortgages. In the latter instance, Bernanke was keen to justify the choice through the logic that mortgages are the main source of funding for SMEs, which are the bread and butter of any economy. Of course they are also ripe for debt-fueled consumption not unlike that witnessed before the sub-prime crisis, but I digress…
The Problem with Untargeted Asset Purchases
In principle, the mechanism is simple. The ECB would come into the markets, buy private and or public debt, which would make it cheaper in secondary, and by association, primary markets. Governments would be able to borrow more cheaply as would consumers and businesses, which would then increase consumption, investment and government spending. The increase in aggregate demand would inevitably stimulate the economy and increase inflation. Regardless of important concerns about the potential bubbles that such a move could create, the Euro-Zone faces other peculiarities that make the practical implementation of such an intervention difficult to foresee.
The EU does not actually have a federal government. The ECB could buy European Commission bonds or EFSF bonds, but those represent relatively small fractions of the Euro-denominated market which excludes them from the role of benchmarks. Then there’s the issue of the private debt sector, where a single market akin to the one in the USA is also not available for intervention. The only truly European market available in EZ financial markets is the interbank lending market. It is therefore not surprising to find this to have been the main battlefield of the ECB since the beginning of the crisis, through a shift in the auction process of lending to banks, acceptance of worse collateral and intermediation throught Target2. However, these were all relatively conventional policies.
Targetted Asset Purchases
One conclusion would be that the ECB is left to intervene in the markets for government bonds of specific countries’ governments. This raises the question of what countries’ debt the ECB should purchase? Given the purpose of the asset purchases, targetting EZ inflation may be inadequate. However, the ideal would be to target the financial markets of those countries most contributing to the EZ HICP fall.
If the idea is to increase consumption and investment where it is most needed, it would make most sense to purchase Greek, Slovakian, Portuguese, Spanish, Irish, Italian, Slovenian, Dutch and French assets, rather than German, Belgian, Austrian or Finnish. The mechanism would be somewhat similar to the SMP (Securities Market Programme), the OMT or the CBPP (Covered Bond Purchasing Programme). The first would imply a limited and unconditional commitment, while the second would imply an unlimited but conditional commitment to purchasing public debt. An intervention along the lines of the third experience would however be focused on Germany and France, which may not really address the issue. The presence of France in that list may warrant some optimism about such an intervention, but I would not be carried away. The ECB’s mandate is to target EZ HICP, not that of any single country, and I would expect there to be much opposition to such a targeted QE programme.
Other venues of intervention for the ECB – Unsterilised LTRO
I remember having very interesting chats with a good friend about this and after going back and forward on it I had to agree that if we were the ones making the decision, we would probably prefer to conduct some sort of unsterilized LTRO. This would save it the trouble of going into asset markets, which are still underdeveloped. It would use a truly European platform and avoid the prickly need to explain its choice of government bonds. The ECB seems to have spending some time thinking about this with Draghi mentioning that “untargetted LTRO, to address liquidity” or a “targetted LTRO , to address lending to the real economy” as well as non-sterilisation are all on the table.
Problem with Unsterilised QE
However, an unsterilised LTRO would keep the ECB in the role of financial intermediator between the north and the south and probably increase in Target2 balances that have created so much commotion… Moreover, while it is similar, it is not really QE. The ECB is taking on the risk of the new loans it creates, but it is not taking it away from the market. An LTRO loan is not the same of an asset purchase. The LTRO loan would actually expand the balance sheet of the ECB and EZ banks, whereas QE would only increase the balance sheet of the ECB, turning banks assets into hard cash…
Food for federal thought
Clearly there does not seem to be any silver bullet to address this problem. The ideal way to do this would be to copy the template of the Fed, the BoE and the BoJ, rather than to reinvent the wheel. This is impossible because there is no governmental counterpart to the ECB in Europe, akin to the role the US Federal government plays vis-a-vis the Fed in the USA. This is yet another reason to consider the creation of a federal EU government in charge of spending, taxing and borrowing more of the money that is now the responsibility of national governments.
PS: On a completely unrelated note, I must explain that other commitments have made it impossible for me to post as often as I’d like on this website recently. This is mostly due to PhD research I have been conducting, which has absorbed most of my attention in the last 6 months, although parallel professional obligations have also played a role. Studying, working and posting clearly appear to form some sort of impossible trinity and this blog has unfortunately been on the loosing side. Nevertheless, I should be able to find the necessary time to post more regularly at the end of the summer. I am still obsessing about the Late Roman Empire and have quite a lot of opinions on the recent Farage-Clegg debate…