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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.