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2014-11-11 07:09:47
Nov 9th 2014, 19:40 by Sony Kapoor | Re-Define
Rounding off our discussion of what the ECB can do to save the euro zone is
Sony Kapoor, managing director of the think-tank Re-Define.
The effectiveness of long-overdue quantitative easing by the ECB will depend on
the quantity and quality of the assets purchased and on the fiscal stance in
the euro zone.
The goal of ECB QE should clearly be to increase inflation and stimulate
growth. Importantly, both of these would also improve debt sustainability. QE
works through central-bank asset purchases that boost money supply; push
investors to reallocate portfolios to riskier assets; increase asset prices and
reduce bond yields. These should help increase investment and consumption,
which the euro zone desperately needs. It should also lead to a further
depreciation of the euro that will help boost exports. Given that the Fed is
exiting QE exactly when the ECB could start firing up, the effect might be
quite significant. The euro has been falling against the dollar in
anticipation.
Given the sharp divergence across euro-zone economies, the distribution of
asset purchases across countries is especially important. To be successful QE
will need to have a disproportionately large impact in France and the
peripheral economies compared to Germany and the Netherlands.
The discussion on how much QE is needed for success must first start with the
recognition that the ECB has messed up. It has shrunk its balance sheet by 1
trillion in the past two years, even as the Fed increased its own by $ 1
trillion. This happened despite the fact that the fiscal headwinds, structural
impediments, unemployment numbers, fragility of the banking system and credit
contraction (partly because of the ECB s own asset-quality review) were worse
in the euro zone. The ECB s recent decision to try to ramp up its balance sheet
back to 2012 levels is important but nowhere near enough.
Improving competitiveness in lagging euro-zone economies without making debt
unsustainable means holding nominal wages down and letting wages rise in the
rest of the euro zone. This puts a downward pressure on inflation in crisis
economies. To ease debt dynamics and prevent a debt-deflation trap, inflation
must be kept positive, ideally close to the ECB s target of 2%. For this to
happen the average inflation in the euro zone needs to be higher, perhaps
3%-4%. Perversely, the ECB has overseen a steady decline in euro-zone average
inflation from 2.7% in 2012 to around 0.3% now. Deflation has already taken
root in some economies and inflation expectations are also falling.
To reach optimal inflation the ECB will need much more than the 1 trillion of
balance-sheet expansion currently on offer. Expanding to the same ratio of GDP
as the Fed will necessitate 2.5 trillion of asset purchases; but given the
worse state of the economy the ECB may need to go further.
Three considerations drive which assets the ECB should buy. Ideally, the asset
class ought to be liquid (ie easy-to-purchase), efficient (ie deliver the
biggest bang for the buck on inflation and the real economy) and large enough
to be macroeconomically significant. Politics dictates that the programme
should be symmetrically designed (open to all countries) but economics calls
for an asymmetric impact in crisis countries. Unfortunately, no asset class
fulfills all criteria.
Large-scale purchases of government bonds will definitely help; but the biggest
impact on the real economy will come only if the fiscal space this provides is
actually used to borrow and invest. For this the provisions of the Stability
and Growth pact will need to be relaxed.
The recently agreed purchase of asset-backed securities (ABS) provides a more
direct channel to the real economy but the market is small compared to the size
of asset purchases necessary. Ongoing covered-bond purchases by the ECB are
useful, though perhaps less efficient than ABS. They are also limited in size
and the biggest issuance comes from Germany (though Spain, France and Italy
would also benefit). The purchase of EIB securities to fund an investment
programme, as suggested by Yanis Varoufakis, is efficient but not yet on the
cards and won t be big enough on its own.
The recently launched TLTRO, whilst not strictly QE, will also help. But its
effectiveness is hampered by a banking system that, despite passing the ECB s
asset-quality review and the latest stress tests, remains fragile.
To maximise impact, the ECB should offer to buy whole portfolios of SME loans
(and possibly other kinds of loans) off bank balance sheets at just below par
and cut the interest rate on these loans substantially. Buying below par will
mean that Spanish and Italian banks will sell but German banks won t. Lower
interest rates will pass through directly to the most employment-intensive part
of the real economy in crisis countries, short-circuiting a broken banking
system. While this goes beyond conventional QE, it may be necessary in the euro
zone s bank dominated system.
While this discussion on the quality and quantity of QE is critical, perhaps
the most determinant for successful QE will actually be a looser fiscal stance.