What Kind of QE?
Many Europe observers already seem to have written off yet another year. To be sure, headlines have not been kind to the old continent, and in particular the euro zone, but mainly this is because of two events:
First, the monetary union fell into deflation for the first time since 2009, with consumer prices falling 0.2 percent in December, dragged down by the rapid and continued fall in oil prices.
Second, uncertainties that surround the Greek elections at the end of this month. They have triggered the sudden return of a term that seemed to have been successfully confined to the rubbish bin of the euro zone’s history, Grexit. The possibility that Greece may leave the euro zone, either intentionally or after being pushed out by a series of tactical mistakes, has rekindled all kinds of doomsayers’ predictions.
Two Problematic Developments: The Greek Election & Looming QE
Despite the potential for these developments to rattle the euro area, European policymakers are about to address them both.
Whatever the result of the Greek election, by March we should know whether Athens will be able to extend or indeed renegotiate its bailout program with international creditors, namely the International Monetary Fund (IMF), the European Commission, and the European Central Bank (ECB). A victory of the anti-establishment and anti-bailout party Syriza is not a catastrophe per se. It would only be so if its head, Alexis Tsipras, were to dig in and refuse to compromise with Greece’s lenders. Given the fact that an overwhelming majority of Greeks still want to stay in the euro zone, I doubt that a populist such as Tsipras would challenge his country’s citizens. Conversely, European partners, including Germany, will not try to muscle out Greece.
On January 22, in order to address the extremely weak inflation of recent months, the ECB is going to announce whether it will launch its own version of a broad-based program of asset purchases, also known as quantitative easing (QE).
To be sure, the deflation/Greece conundrum has once again put the ECB on the spot. And once again the ECB is described by many international investors as overly constrained by politics, unable to meet its obligations because of deep internal divisions. Even skeptics don’t question that the ECB is about to launch QE. What they do question is that the central bank will be bold enough and be able to lift inflation and growth in the euro area.
ECB Suicide: An Unlikely First Option
Battle lines are defined in clear terms: critics contend that any asset purchase program that falls short of unlimited purchases of a variety of assets, primarily government bonds, for an unlimited period of time, would simply fail to lift inflation expectations to a level consistent with the ECB’s mandate of an inflation rate below but close to 2 percent. These skeptics are worried by an option at the other end of the spectrum that seems to be backed by the German Bundesbank. Under such an alternative scenario, instead of the ECB it would be the euro system’s national central banks that would be tasked with purchasing government bonds issued by their own national governments. Designed in such a way, the program would protect the balance sheet of the ECB—it would keep risks confined within national central banks (NCBs) and individual member states. It would therefore address both articles 123 and 125 of the treaty on the functioning of the EU that forbid the central bank from monetizing debt and bailing out individual member states. But such a QE would be problematic. It would be perceived by investors as a sign that the euro is not irreversible and the ECB is in fact reluctant “to do whatever it takes” to save it. Such a program would worsen the negative feedback loop between banks and their sovereigns and would deepen the current fragmentation in the euro area.
Since I believe that the ECB is reluctant to commit suicide, I don’t think that this plan has legs.
Unlimited QE, in All But Name
But I also doubt that open-ended, unlimited QE is a real possibility. The more realistic outcome is something in between, a program that relies on capital key based purchases of sovereign bonds, with shared risk, but capped at an upper limit and equipped with a clear timeline that could be extended, if necessary. Combining a cap and a timeline should be able to address some of the underlying German concerns. However, since such a program would fall short of what markets deem necessary in order to awe investors, the initial headline number and the amount of monthly purchases would have to be very big. Also, there should be no room for a more restrictive interpretation that could undermine the ultimate effectiveness of the program. QE is mostly about signaling. Weakening the message means destroying it.
This is why I am not sure that merely buying €500 billion worth of investment-grade securities, mostly government bonds, would be a big enough figure able to convince international investors that the ECB is really serious about the program. A comprehensive QE with a big headline figure—something closer to a trillion euros—would be far more effective. Of course, such a decision would require a high degree of confidence among the majority of the governing council’s members that increasing the size of the balance sheet dramatically is practically and legally feasible and would have a real impact on inflation in the euro zone.
Alternatively, the ECB could stick to a smaller figure and shorten the time horizon, but markets would immediately price-in a second QE program. Once the Fed announces its first rate hike after the end of QE in the U.S. (to be decided not before April, but probably at one of the following Federal Open Market Committee gatherings), the end of the euro zone’s own QE program only months later would become more difficult to implement, as ending euro QE prematurely could trigger serious market turbulences, especially if the euro area’s recovery remains weak, fragile, and uneven. As recent market swings have shown, investors’ confidence still hinges on central banks’ behavior, a further sign that even in the United States, we are still far from back to normal. The Fed and the ECB will have to manage the transition from unconventional to more conventional monetary policies in a way that does not heighten the risk of serious financial disruptions. Euro area QE will need to continue for some time after the Fed’s first key nominal rate increase.
Packaging Sovereign Bonds, and The Role of The Banking Sector
Carlo Bastasin of the Brooking Institution has proposed an alternative purchase program, one that would address the lack of a truly safe, liquid, common asset in the euro area. He proposes that banks—who hold the majority of sovereign bonds issued by euro area countries—would be asked by the ECB to package sovereign bonds into securities according to the ECB’s capital key levels. Issuance of such asset-backed securities (ABS) would have multiple benefits: it would create a safe, highly liquid asset, and it would avoid any direct purchases of sovereign bonds by the ECB. It is a tempting proposal, as it would also allow the central bank to re-introduce the notion of Eurobonds, something that banks crave, given the growing difficulties of managing liquidity requirements in a tougher regulatory environment.
I see two problems with such a proposal. First, the link between sovereign-based ABS and Eurobonds is too evident and would trigger a massive political backlash in creditor countries. It is one thing to isolate the Bundesbank within the ECB, quite another to openly challenge Germany’s chancellor Angela Merkel.
Second, I doubt that euro area banks would play ball. In the present environment, unsure of how strict their new supervisor is going to be, credit institutions would gladly buy some form of Eurobonds if they existed, but they would be more reluctant to create the assets themselves and sell them to the ECB. So far the comprehensive assessment of banks’ balance sheets undertaken by the ECB and the European Banking Authority (EBA) has failed to boost bankers’ confidence in the robustness of their balance sheets or, for that matter, the European recovery. According to multiple media reports—including the Financial Times and Italy’s “IlSole 24 Ore—the Single Supervisor of Banks (SSM), in other words the ECB, has even quietly asked a number of banks in Italy and Spain,Banco Santander among others, to further increase their capital buffers to levels well in excess of what the internationally-mandated Basel lll accord requires.
The overhaul of the European banking sector is far from over. Indeed in some countries, such as Italy or even Germany, the need for consolidation in the banking sector will only grow in the near future. If true, this determined and intrusive action by the SSM would confirm that the new regulator takes its new duties seriously and intends to speed up the overhaul of the banking sector in Europe.
However, given the over-reliance of the old continent’s economy on banks, this also means that even in 2015 many credit institutions could remain reluctant to extend new loans to households and non-financial corporations. Such a development would complicate matters greatly for monetary policies. Pumping additional liquidity into the financial sector via QE while at the same time making it harder for banks to extend loans would be like pushing on the gas pedal while at the same time slamming on the brakes. Additional capital requirements may make sense for individual, vulnerable credit institutions, but they would be counterproductive for the whole banking sector in individual countries or indeed the whole of the euro area.
Concluding on the Effectiveness of European QE
I fear that given the current state of play in the financial sector of the monetary union, QE is primarily going to be effective because of its impact on foreign exchange markets. A weaker euro will certainly help the euro zone, including Germany’s export-driven economy, but will it be enough to spur lending and investments? Even senior ECB officials who endorse action are not sure that QE will meet all intended targets. Executive board member Benoit Coeure told a German newspaper that the impact of QE on inflation is “difficult to forecast. In America government bond purchases were unquestionably successful. The question is how that can be transferred to a monetary union like ours. … That makes things more complicated, but it’s no justification for doing nothing at all.”
Getting the balance right in Europe has always been difficult. But all too often throughout the crisis, the need to stick to a balanced approach has blinded policymakers into believing that finding a compromise is more important than making a choice. If the ECB wants to push inflation higher and turn the overly pessimistic narrative about the state of the monetary union into a more hopeful message, it will need to surprise with a clear, unmistakable act of courage.