Mario Draghi, the European Central Bank president, announced an asset-purchase programme worth around 1.1 trillion euros ($1.3 trillion), or 60bn euros a month until the end of 2016, on Thursday afternoon.
Here we explain the workings of QE, its track record, and its outlook as a restorative measure for Europe.
How does quantitative easing work?
Central banks buy assets from the open market including banks and dealers. Banks get cash, which they use to issue more credit. Companies take out more loans, spurring investment; consumers spend more on their credit cards. Banks place more money on the stock markets, since returns on equities are greater than the returns to cash. This benefits shareholders, who receive capital gains and higher dividend payments, and companies, whose higher stock prices increase their borrowing power. At least – that’s the theory.
Does it work?
QE may work. But many economists think that Europe could be in a balance-sheet recession – which would make further monetary easing ineffective. It is also thought that the ECB has waited for far
too long. When inflation gets close to zero, inflationary expectations change. When companies expect inflation to remain low, they do not significantly change their prices, which in turn keeps inflation low. This is how low inflation can become permanent.
What is a balance-sheet recession?
A balance-sheet recession occurs when high levels of private debt cause consumers and companies to focus on paying down or reducing debts, rather than increasing spending or investment. When net solvency (the assets of a company or household minus its liabilities) falls below zero, it is rational for that company or household to pay back debt no matter how cheap it becomes to take on additional liabilities. Japan entered a balance-sheet recession in the 1990s, when a collapse in land and stock prices dramatically increased firms’ net liabilities and reduced their net worth – leading them to try to pay down debt, despite interest rates falling below zero.
And this is the cure?
It is not clear that QE can solve the unique problems of balance-sheet recessions. When households and companies have negative net solvency, cheaper borrowing costs will not encourage them to increase lending. QE may allow borrowers to restructure the term and interest components of existing debt – but, by itself, that will not do a lot to get firms investing and consumers spending again. When net solvency is negative, actors will focus on returning to a neutral asset position. But with an economy in recession, this becomes harder to do – and chasing debt repayments at the aggregate level does nothing to boost the economy. The Nobel laureate Paul Krugman, and the economists Atif Milan and Amir Sufi in their book House of Debt, argue that debt relief and fiscal stimulus are crucial to addressing balance-sheet recessions – and that QE alone won’t do much.
Has QE worked in Japan, the UK and the US?
The evidence is mixed. It is clear that the accommodative monetary policy stance of central banks has worked better than the restrictive stance of the Federal Reserve during the last great crisis of financial intermediation – the Great Depression. This time around, we know that stock markets have benefited. The S&P 500 reached a record high on December 29, after a year of gains driven by all the extra cash the Fed gave to banks. But QE is an indirect way of stimulating the economy. Lifting the S&P 500 may not be the best way to encourage economic growth. Dividend payments and capital gains mainly benefit wealth-holders, and only very indirectly affect everyday consumers.
What is the ECB already doing?
The ECB currently buys private sector bonds for a period of three years. It also purchases asset-backed securities – products whose value changes based on the value of and income from the underlying asset, which are kept off-balance sheet – and covered bonds, which are asset backed securities kept on a bank’s balance sheet. QE would see the ECB buy sovereign debt.
What do the Germans think?
Germany has objected politically and legally to straightforward QE – which would result in the ECB itself buying up institutional debt. So, where the ECB would otherwise bear the risk of losses on sovereign debt on its own balance sheet, it is expected to ask national central banks to cover any losses on its purchase of the debt of their countries – the Bundesbank would be responsible for any losses on German sovereign debt, the Banque de France for any losses on French sovereign debt, and so on. German politicians argue that straightforward QE causes “moral hazard”. By effectively insuring governments against the consequences of their actions, governments feel free to engage in risky, profligate spending policies – or so German politicians argue.
Is everyone else on board?
No. The IMF has said that this is worse than straightforward QE, while the Irish finance minister, Michael Noonan, has strongly criticised the proposal. Periphery economies – Portugal, Italy, Spain – are at greater risk under this model. If investors believe that national central banks are simply propping up insolvent governments, sovereign debt crises could result. Investors might view nations as printing money to prop themselves or their companies up – and take flight. If the ECB were to buy bonds, by contrast, the solvency risk to the ECB would be shared among every euro zone member.
What will the impact be?
Limited. It may well be too late for the euro zone – economists have been calling for more action for a long time. Inflationary expectations are hard to shift: once ingrained, they can take years to change. And a nation-based QE scheme could backfire if it precipitated further sovereign wealth crises.
Is there an alternative?
Well, probably. Simon Wren-Lewis, a macroeconomist at Oxford University, says that direct transfers to citizens could be more effective than current examples of QE. On his blog, he argues that “in the short run the effectiveness of QE is highly uncertain compared to the effectiveness of direct transfers to citizens or public works. We seem to be stuck with an ineffective form of stimulus, because something more effective is taboo, or goes by a different name.
“To repeat it in a simple but more provocative way: a central bank giving money to people or governments is out of the question, but a central bank giving money to parts of the financial sector is just fine. That is a very convenient taboo for some.”
abouyamourn@thenational.ae
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