Author: Jules Gray
22 Mar 2015
The eurozone crisis proved to be a devastating period in the EU’s short history. It shredded the credibility of the monetary union that pro-integration politicians had long been calling for and made the differences in wealth and stability between member states all the more stark.
For leaders of the eurozone, warding off any potential return to the debt crisis has been the priority of the past year. With the economic situation in Europe hardly improving, many people have called for a drastic rethink of the policies that have been employed over the last few years. Among those voices has been ECB President Mario Draghi, who has long called for a massive round of quantitative easing in the eurozone, on a scale adopted by the likes of the US and UK at the height of the global financial crisis, but so far resisted by many European economies.
Draghi finally succeeded in January, when he announced the ECB would begin a series of
After many months of speculation, Draghi finally succeeded in January, when he announced the ECB would begin a series of bond buybacks he hoped would restore confidence in the troubled economic area. Amounting to at least €1.1trn worth of bond buybacks he hoped would ward off potential deflation within the eurozone, Draghi said the scheme would mean around €60bn worth of QE per month. This is a considerably higher amount than many had expected.
In a statement announcing the move, the ECB said it took the decision after EU inflation had hit a historical low. “This programme will see the ECB add the purchase of sovereign bonds to its existing private sector asset purchase programmes, in order to address the risks of a too-prolonged period of low inflation. The governing council took this decision in a situation in which most indicators of actual and expected inflation in the euro area had drifted towards their historical lows. As potential second-round effects on wage and price setting threatened to adversely affect medium-term price developments, this situation required a forceful monetary policy response.”
According to Adam Posen, President of the US-based Peterson Institute, the €1.1trn may not be enough to prevent deflation. “It will make some difference. It’s not going to be enough to fully offset deflationary forces, let alone restore growth, but the degree that Draghi was able to make it sound open-ended is a good thing. Ultimately, €1.1trn over 18 months versus euro area GDP is roughly a third of what the Bank of England or Federal Reserve did under similar circumstances, and it’s likely to take more money to get the same effect in Europe right now”, he told The Telegraph.
What is QE?
The process of QE will involve the ECB printing lots more money; money it hopes will encourage people and businesses to spend more within the EU, as well as spur investment. By acquiring government bonds from struggling EU member states, individual governments can set about investing elsewhere. The hope is this will then force prices up, and increase the flow of money within the eurozone. As Nick Barnes, Head of Research at property agency Chestertons, says, the plan for higher asset prices may have a direct beneficial effect: “Higher asset prices mean lower yields, which brings down the cost of borrowing for businesses and households, which should provide a further boost to spending. In addition, much of this new money is likely to end up with banks which might lead them to boost their lending to consumers and businesses.”
However, Barnes also notes QE has not always proven successful: “Japan tried it to escape the effects of its ‘burst bubble’ at the start of the 90s and has yet to recover fully, while opinion is divided about how much QE contributed to the UK’s economic turnaround in 2013. Even if the banks’ coffers swell, there is no guarantee that this extra capital will then filter through to households and corporates, as many banks are more cautious about lending following recent regulatory tightening, or they may use it to shore up their balance sheets, for example to cover fines for misconduct. Finally, households and corporates may prefer to reduce debt rather than take on additional debt and spend. There is the additional risk that an asset price bubble will be created without gaining traction on the real economy, which could have major global ramifications.”
QE for the people
Quantitative easing might be better targeted if it were coupled with expansionary fiscal policies and the full amount gifted directly to the people, writes Matt Timms
Few, if any, were surprised when the ECB unveiled its QE programme, yet the policy was always likely to spark lively discussion among its most ardent critics.
“The ECB’s quantitative easing must target the real economy”, came the cry from Unconditional Basic Income Europe (UBI), whose call for a more equal policy was given fresh impetus. “QE for the people (QEP) is not just a more efficient approach for directly stimulating the real economy, it is also more fair in the current context of deep social inequalities and the rise of extreme poverty in the eurozone”, said UBI’s Thomas Fazis, and so began a fresh debate about an alternative approach to QE.
Rather than doling out the €60bn per month to lenders and waiting for the effects to trickle down, proponents of QEP argue that gifting the money directly to citizens would represent a more targeted approach to alleviating the issues at hand. Not doing so, they say, would merely inflate asset prices and benefit the rich, given five percent of the population lays claim to over 40 percent of the region’s assets. Should the ECB change its current strategy and place the same amount in its citizens’ pockets, each person would be gifted an additional €2,100 on top of their annual earnings.
True, the policy is a far cry from the present programme, yet economists, including John Muellbauer of Oxford University and Sylvain Broyer of Natixis, insist QEP could work. The criticism rings loud and clear that such a system would only lead to inflation, yet the same can be said for the ECB’s chosen method, with the only difference being that a more complicated feed-through process obscures how much of an effect the programme is having on the real lives of people in the eurozone region.
QE has been widely hailed as one of the main reasons the US and UK economies have recovered comparatively strongly since the global financial crisis of 2008. While many suggested it was too risky a strategy to employ and that low interest rates and more money would mean currencies would plummet in value, it has in fact proven successful in both countries. While the eurozone insisted on not adopting QE, the countries that did softened the blow of the crisis and prevented mass unemployment. By contrast, eurozone countries have faced double-dip recessions, a stunning debt crisis, and an ever-increasing likelihood that the euro might collapse less than 20 years after being launched.
The need for some form of drastic shock to the eurozone has grown starker over the last 12 months, after a period of relative stability. Europe’s most troubled economy, Greece, has flirted with political instability over the last year, ultimately leading to the election of the far-left, anti-austerity Syriza party in January. What led to its election was the perceived unfairness of the austerity programme imposed on the Greek people by the ECB, IMF and World Bank. However, it is the German dominance of the eurozone that has led many Greek citizens to call for a renegotiation of their bailout packages, threatening the integrity of the already-fragile European economy.
At the same time, the eurozone’s recovery has been sluggish compared to many other economies following the global financial crisis. While the UK and US used quantitative easing to seemingly great effect, Europe’s reticence has led many to call for a similarly bold approach to kick-start the economy. Draghi’s desire for QE comes from a need to address the situation in the south of Europe, where economies are still struggling to get their finances in order and cut their huge piles of debt. Large-scale unemployment has beset Greece, Spain, Italy and many other eurozone members.
Gaining ECJ approval in early January, Draghi’s Outright Monetary Transactions scheme received the go-ahead later in the month, after a legal challenge from Germany’s constitutional court in 2014. The challenge came as a result of concerns in Germany over how much exposure its taxpayers would face as a result of the massive bond buying plan. Germany was concerned the risks associated with QE would be too heavily placed on their own economy, rather than on individual member states. So, to placate any dissenting voices, Draghi stated risks would be shared, and that any rounds of bond buying in specific member states would be done with the countries’ central banks solely responsible for the risks.
It has been argued that, because of this fragmented approach, the eurozone’s QE programme is unlikely to be as effective as the sort of bond buying used by the US and UK. With just 20 percent of the purchases subjected to risk sharing across the eurozone, national central banks will ultimately be responsible for the vast majority of any losses hitting their bond buying. While many in Germany will be relieved at this compromise, it is likely to temper the effects of the strategy.
The QE plans have had an unwelcome knock-on effect for a number of industries and companies. In early January, the Swiss National Bank (SNB) sent shock waves through the foreign exchange markets when it decided to abandon efforts to peg the Swiss franc to the euro. The pegging, instigated in 2011, was done after a decade-long period of difficulty for Switzerland’s economy. After signs QE would be implemented across the eurozone, bringing down the value of the euro, Switzerland was so concerned about the potential impact on the country’s exports that it immediately withdrew from the pegging.
As a result, a number of foreign exchange brokers suffered severe losses. During a single day’s trading, the Swiss franc jumped by as much as 39 percent, eventually settling at around 20 percent up from its previous figure before the pegging was scrapped. The UK arm of Alpari lost around £30m as a result of the soaring Swiss franc and was forced to close. Another firm, New York-based FXCM, suffered a $225m loss thanks to the volatility of the currency.
Traditionally seen as a safe-haven economy, Switzerland has been favoured by wealthy investors for its apparent immunity to serious economic risk. Unfortunately for the economy, this assumption drove the value of the Swiss franc up 30 percent over the last decade, leading to exports becoming unsustainably expensive in a country so reliant on selling its goods abroad. As a result, the SNB took efforts to peg the currency to the euro, so export prices would be reduced. However, with QE leading to an influx of euros to the economy, continuing with the peg would now have meant harming exports.
One country that didn’t buckle under the pressure of impending QE was Denmark. Having pegged its currency to the euro ever since its inception in 2001, and before that the German deutschemark since 1982, Denmark has sought to maintain its links to the euro regardless of the impact of QE. According to the national bank, Danmarks Nationalbank, the country would do “whatever it takes” to maintain the Danish krone’s peg to the euro. The bank has repeatedly cut interest rates already this year in an effort to keep the krone close to the value of the euro. However, some analysts are of the opinion that the pressure derived from the ECB’s massive QE programme could ultimately mean a scrapping of the peg is inevitable for Denmark.
Lessons from the past
QE has been attempted before, with mixed results
Japan – QE was first attempted by the Bank of Japan in 2001, to counter persistent domestic deflation. The goal was to promote lending by flooding commercial banks with excess liquidity, by way of purchasing government bonds. This was unsuccessful: inflation was not created and the attempt is still cited as a cautionary tale, though later Japanese QE programmes fared somewhat better.
US – In November 2008, the US Federal Reserve embarked on a bond-buying programme that began at $85bn per month (slowing to $15bn per month, before ending in 2014). Capital was freed up, softening the risk-averse post-crisis mood and boosting the Federal Reserve’s coffers from $870bn in mid-2007 to $4.5trn at the beginning of 2015.
UK – In 2009, the Bank of England announced its goal of spending £75bn over three months and cutting interest rates to 0.5 percent. From then to 2010, the Bank bought assets equal to 14 percent of UK GDP. This drove up share and bond values, benefitting the rich but doing little for the majority, though the Bank argues the resulting job creation benefitted everyone.
In Nick Barnes’ aforementioned Chestertons report in February, he discussed QE’s potential impact on the market. The report claimed: “With the eurozone equivalent of our bank rate already dangerously low at 0.05 percent, this was seen as the only feasible shorter-term alternative. The jury is out on whether the planned €60bn per month allocated to the programme for at least the next 19 months will achieve its objectives. Either way, the move will have implications for the UK economy, including its residential property market.”
For a number of years now, the London property market has risen to such a level that it has been seen as an investment tool in itself. Barnes believes QE could have a positive effect on London’s property market. “If QE, which offers nothing by way of addressing the structural issues which plague Europe, does not achieve its objectives and the Euroland economies stagnate further, stock markets would become more volatile and the euro would almost certainly experience further decline. Given this scenario, alternative assets would receive increased investor interest. Property, offering both potential capital gain and rental income, should again be an attractive option. With a large and fast-growing privately rented sector and a solid long-term track record of capital growth, London would stand out as an obvious target. Given its proven global appeal, the London residential market additionally offers above-average liquidity among its peers, which would reassure investors with an eye on their exit strategy.”
First steps to growth
Draghi has maintained that his adoption of QE is an important step towards spurring growth within the eurozone. However, he has also been very clear that it is only a first step, and he has openly stated that the real thing European economies need to get to grips with is encouraging investment. “What monetary policy can do is create the basis for growth, but for growth to pick up, you need investment. For investment you need confidence, and for confidence you need structural reforms. The ECB has taken a further, very expansionary measure today, but it’s now up to the governments to implement these structural reforms, and the more they do, the more effective will be our monetary policy. That’s absolutely essential, as well as the fiscal consolidation side. So, structural reform is one thing, budget and fiscal consolidation is a different issue. It’s very important to have in place a so-called growth-friendly fiscal consolidation for confidence strengthening. This, combined with a monetary policy, which is very expansionary, which has been and is even more so after our decisions today, is actually the optimal combination. But for now, we need action by the governments, and we need action also by the commission, both in overseeing fiscal policies and in implementing the investment plan, which was launched by the president of the commission, which was certainly welcome at the time, and now has to be implemented with speed. Speed is of the essence.”