The European Central Bank announced a 1.1 trillion injection into the ailing eurozone economy on Thursday, which was more money than expected. The ECB, which is the central bank for the eurozone, promised to buy bonds worth 60 billion per month until at least the end of September 2016 as part of a programme of quantitative easing (QE). They will also hold interest rates at a record low of 0.05%.
The programme begins in March, and the ECB hopes it will revitalise a flagging economy, but what do all these numbers mean? What exactly is quantitative easing, how will it help, and is it even guaranteed to work? Let’s dig in.
QE is a policy tool central banks use to indirectly encourage consumer and business spending in an economy. A central bank, such as the Bank of England, creates money to buy financial assets. The increased demand for those assets lowers their yields. The theory follows that commercial interest rates are subsequently pushed downward, which encourages people and businesses to borrow, and subsequently spend.
That spending then creates jobs and boosts the economy. A good example of this would be a person who’s thinking of building a house, and decides to go for it since mortgage rates are low. The money from the bank loan then gets spent on contractors, supplies and possibly furniture, boosting the health of those other businesses.
The policy has been tried before in the UK, United States and Japan. In the UK and U.S., the policy has been deemed successful; in Japan, however, opinion is fiercely divided. Importantly, though, they were all single markets with a central bank. One difficulty facing the eurozone is the disparate economic health of the 19 member states, which makes a one-size-fits-all policy approach potentially less effective.
Another potentially significant hurdle is that the ECB will not just be buying directly from financial institutions, but rather from the governments of individual member states. This adds a link to the top of the chain, extending the domino effect needed to push down interest rates and encourage borrowing and spending.
ECB president Mario Draghi said that a “large majority” on the ECB governing council voted in favour of the bond-buying programme but many remain sceptical — Germany in particular.
Andrew Sentance, senior economic adviser to PricewaterhouseCoopers, thinks the ECB has left it too late. He points out that the UK and U.S. were much quicker to implement a programme, and Japan’s experience in the 1990s suggests that “delaying policy responses allows economic and financial problems to become more deeply embedded.”
Quantitative easing also depends for its success on being able to lower interest rates enough to encourage new borrowing, which can be difficult if rates are low already.
“Also, longer term interest rates in the eurozone are already very low, which reduces the scope for QE to influence financial markets by pushing down bond yields,” he adds. Sentance also points out that QE doesn’t address structural factors, such as the weak growth in France and Italy, two countries that account for nearly 40% of eurozone GDP.
Another concern is that the money actually reaches eurozone businesses, “rather than flowing to, and through, bank balance sheets via government bonds,” as John Longworth, director general of the British Chambers of Commerce warns. If, for example, banks tighten lending standards and refuse to issue new loans, then the chain of effects stops there, instead of continuing to flow downstream as spending. Of, if individuals don’t have enough confidence in their economic prospects, they may refuse to borrow regardless of the lowered interest rates.
There are 19 different member states in the eurozone, and each country’s economic health differs wildly. Debt levels vary and Portugal, Ireland, Italy, Greece and Spain in particular are worse off than the rest. Prior to currency unification, exchange rates allowed for adjustment between currencies (reflecting the health of the country’s economy), a major tool that is no longer available.
The EU has long been seen as a two-tier economy, with more prosperous nations driving decision making. In Thursday’s announcement, Greece is currently excluded from the QE programme because their debts are not “investment grade.” However Draghi did say that in July redemptions of Greek bonds may allow the central bank to buy more from Greece, if conditions are met. However that will be up to the Greek government and that depends on who wins the upcoming election.
The QE programme in the U.S., which saw the U.S. Federal Reserve buy $4.5 trillion of bonds and wrapped up last year after six years, was seen as a success. Ditto the UK. But these were run by central banks in single countries.
The ECB must tailor the policy to 19 different countries whose policymakers have wildly different attitudes to monetary policy.
From a trickle-down perspective, the effect of the package on average Europeans could be less than that experienced in the U.S. because long-term interest rates, which QE is supposed to lower, are already low in Europe. In the U.S. rates were higher when the Federal Reserve started to buy bonds.
That’s the €1.1 trillion question. The eurozone is currently supping in the last chance saloon, and one commentator, Dennis de Jong, the boss of trading site UFX.com, said the move is “seen by many as the last roll of the dice for the beleaguered euro.”
One unknown is when the stimulus package will end; it has been indicated that it would run to September 2016. However, speaking today, Draghi left the door open, saying purchases would be “conducted 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.” Read more…