European Central Bank's last throw of the dice

January 23, 2015 10:10 JST

The European Central Bank has finally fallen into line with its peers in the U.S., U.K. and Japan by launching its own program of quantitative easing.

ECB President Mario Draghi on Thursday announced that the Eurosystem of the EU member states' central banks would start in March to buy public and private bonds at the rate of 60 billion euros ($68 billion) a month until mid-September 2016 or, he noted, "in any case until we see a sustained adjustment in the path of inflation which is consistent with our aim of achieving inflation rates below, but close to, 2% over the medium term."

On the surface it all sounds pretty impressive, even if a few years late. It is unquestionably a significant step and worth taking. On closer scrutiny, though, while the ECB will likely be able to achieve some intermediate financial goals, it will fail by acting alone, without the support of member governments, to realize its grander and more important economic goals. Amid concerns expressed by some Eurozone members, notably Germany, the ECB is also potentially moving further into political quicksand that could undermine its authority.

What has the ECB done?

The ECB's aim is to boost the size of its balance sheet from just over 2 trillion euros back to about the 3 trillion euro level reached after the introduction in 2012 of its so-called long-term repurchase operations (loans to banks that boosted their liquidity). Since then, and especially in 2014, the size of the central bank's balance sheet has fallen -- even in the face of gathering deflationary pressures, and despite the ECB's decision to start buying asset-backed securities and covered bonds in late 2014.

Purchases of these private-sector assets, however, have been relatively small, averaging about 10 billion euros a month since November. Assuming this pace persists, the ECB intends to make monthly purchases of 50 billion euros of sovereign bonds and the bonds of EU agencies, for a monthly total of about 60 billion euros. Purchases will be roughly in line with Eurozone members' proportionate contributions to the ECB's capital.

There had been considerable speculation before the announcement about whether national central banks in the Eurosystem would be required to take the risk of bond purchases on their balance sheets, or whether the risk should be mutualized at the ECB itself. In any event, and in deference to the wishes of northern creditor countries, particularly Germany, the ECB has stipulated that 80% of the risk of bond purchases will lie with national central banks. The remainder will be mutualized in the form of agency purchases, and bonds owned by the ECB directly.

Draghi seemed to downplay the significance attached to doubts raised by economists and financial commentators about who bears the risk. It is of some importance, since making national central banks responsible goes against the spirit and intent of a common monetary policy in a monetary union, and sustains the possibility that in the future, there may be differences in the monetary policies of national central banks. This would doubtless reduce the effectiveness of the QE effort.

But this issue, and the potential emergence of legal and contract issues, are for another day. The more immediate -- and understandable -- concern will be about whether the ECB can achieve the macroeconomic goals that have come to be expected of QE, and what the implications might be beyond Europe, including for Asia.

Will the ECB succeed?

The immediate reaction to the ECB's announcement in financial markets was predictable. The euro dropped to an 11-year low against the dollar, equities rallied, and already-low bond yields fell further. In Germany, about three-fifths of the nominal value of bonds outstanding were trading on negative yields. This is all par for the course, and echoes how financial markets have reacted in response to other countries' QE programs.

Draghi, however, is looking to do much more than boost financial markets, get investors to buy riskier assets and drive their prices up. He said in a prepared statement that the ECB wanted to underpin the anchoring of medium- and long-term inflation expectations, improve financing conditions for companies and households, and strengthen demand, capacity utilization, money supply and credit growth, and hence ensure inflation rose again toward 2%.

This is important not just to Europe but to other geographic regions too, notably Eastern Europe, and also Asia. Europe's economic funk and the deflationary conditions running through its arteries comprise one important reason for the drastically different world trade environment now stymying many emerging economies. So it is important that the ECB succeeds.

The QE effort will be judged first and foremost on this inflation criterion, and the empirical evidence from the U.S., U.K. and, most recently, Japan is not encouraging. In no other major country where QE has been deployed has the policy succeeded in pushing up and sustaining targeted inflation. In Japan, the depreciation of the yen and the sales tax rise did push up the consumer price index, but the gauge is now headed back down again.

There has not been significant strengthening in wage income formation that could help to sustain higher inflation, and money and credit growth has only really firmed in the U.S., where QE had little to do with loan demand by companies.

Fans of QE also overlook the important preconditions for successful easing programs in the U.S. and U.K., which included early and forced bank recapitalization and budgetary stimulus, or at least the absence of Eurozone-style austerity programs. Even now, it is inconclusive whether QE alone actually helped revive economic growth in the U.S., U.K. and Japan. It certainly did not prevent Japan from lapsing back into recession last year.

Given the dire state of the Eurozone economy, QE is unlikely to push inflation markedly higher, especially in the periphery countries such as Greece, Spain, Italy and Portugal. Under these circumstances, it is inconceivable that others, such as Germany, would be willing to experience significantly higher inflation to compensate. In fact, there probably is no successful QE policy that, in addition to longer-term labor and product market reforms for debtor and creditor nations, does not also rely on comprehensive debt restructuring and relief, properly recapitalized banks, and greater fiscal activism by countries and institutions that are able to implement it. If Europe is to experience a sustainable rise in demand, investment, jobs and productivity, these policies must accompany QE -- but no one expects the prevailing policy stance to change so much.

This is not to criticize QE as such, but to lament the absence of complementary policy measures, and point to the risk of a political backlash among creditors and among voters generally against the single-minded emphasis on the ECB.

What about the rest of the world?

European QE will probably not affect the global financial system in the same way as did America's QE, given the crucial global role of the dollar and dollar-denominated capital markets. That said, financial euphoria in Europe should have a knock-on effect abroad -- in the short term, at least. A weaker euro against the dollar and against currencies linked, however loosely, to the dollar, will clearly result in losses for investors holding euro assets, but perhaps also give potential purchasers new buying opportunities.

That said, European QE is unlikely to result in the same sort of capital flow controversies that surrounded the U.S. Federal Reserve's easing program. Europe already exports about $200-300 billion in capital a year, representing the other side of the European balance of payment surplus, so the ECB's QE could, at the margin, result in higher capital outflows. But it is doubtful these would destabilize emerging countries in the ways that critics blamed on U.S. QE.

What Asia really wants from European QE is a stronger, more vibrant Eurozone economy that imports significantly more from Asian producers. Some things may contrive to work toward this, including the effects of lower oil prices, low bond yields, early stage banking union initiatives -- and now, the ECB's opening of the monetary spigot. However, as suggested, the ECB acting alone is highly unlikely to be able to deliver the outcome it and everyone else wants. We should be braced for disappointment, as well as the destabilizing effects of an even stronger dollar.