We have long held the belief that unlike other parts of the world, quantitative easing (QE) could actually accomplish a lot in the eurozone.
QE is central banks purchasing long dated assets like public bonds. Buying shorter assets is considered part of normal open market operations to establish target interest rates and liquidity to the banking system. When short-term interest rates are effectively zero and the economy is still producing way below capacity, QE can be considered as an additional tool.
This is what the Bank of England (BOE) and the Fed have done in the wake of the financial crisis, and it is what the Bank of Japan has done for six years in the last decade. The economic conditions under which this instrument was applied were quite similar in each of these cases. A credit-infused asset bubble imploded, leaving ravishing balance sheets of households, banks and/or firms.
In order to restore balance sheets, spending, borrowing and lending goes down, creating a savings glut and an output gap (the economy producing way below capacity), rising unemployment and falling asset prices. This Fisherian debt-deflationary process can easily feed on itself, hence the need for rather strong policy action. If not, the economy can easily slump into a 1930s style depression.
QE is one of these stronger policy actions. Normal monetary policy has a habit of being near completely ineffective. Central banks lowering rates and flooding banks with liquidity isn't going to revive borrowing and spending, as people prefer to pay off debts at any interest rates.
Banks simply sit on the excess reserves, as credit demand under these conditions is weak.
How QE would help isn't immediately obvious. In essence, it means the central bank buying assets (although now longer dated assets or other stuff like mortgage backed securities) from banks, flooding them with even more liquidity. One might hope long-term interest rates (which matter more for the economy than short-term ones) will decrease.
The evidence suggests that there might be a mild reduction in long-term interest rates, but these are already at or near decades lows. So lowering them a little bit further cannot be expected to have a dramatic impact on the economy. Additional mild effects might be produced in the form of rising other asset prices, like stocks but we haven't seen any studies pointing to convincing effects
In the eurozone, QE would work
Indeed, the recent rally in stocks and bonds from peripheral eurozone countries is premised on the ECB embarking on QE. In the eurozone, bond yields of peripheral countries are at anything but decades lows.
Paul de Grauwe, a well known Belgian economist and expert in monetary integration, compared the situations of the UK (outside the eurozone) and Spain (a eurozone member). He concluded that the large gap in bond yields cannot be explained by the differences in the respective fiscal positions, and pointed out the possibility of self fulfilling 'multiple equilibriums' for the debt issued by members of a currency union.
It is worthwhile to quote the De Grauwe paper, one of the most important on the eurozone crisis, at some length. Here is de Grauwe explaining what happens when investors fear a UK default and start selling its debt:
In that case, they would sell their UK government bonds, driving up the interest rate. After selling these bonds, these investors would have pounds that most probably they would want to get rid of by selling them in the foreign exchange market. The price of the pound would drop until somebody else would be willing to buy these pounds. The effect of this mechanism is that the pounds would remain bottled up in the UK money market to be invested in UK assets. Put differently, the UK money stock would remain unchanged. Part of that stock of money would probably be re-invested in UK government securities. But even if that were not the case so that the UK government cannot find the funds to roll over its debt at reasonable interest rates, it would certainly force the Bank of England to buy up the government securities. Thus the UK government is ensured that the liquidity is around to fund its debt. This means that investors cannot precipitate a liquidity crisis in the UK that could force the UK government into default.
Contrast this with what would happen in Spain in the similar scenario where investors flee because the fear a default, selling Spanish bonds:
The investors who have acquired euros are likely to decide to invest these euros elsewhere, say in German government bonds. As a result, the euros leave the Spanish banking system. There is no foreign exchange market, nor a flexible exchange rate to stop this. Thus the total amount of liquidity (money supply) in Spain shrinks. The Spanish government experiences a liquidity crisis, i.e. it cannot obtain funds to roll over its debt at reasonable interest rates. In addition, the Spanish government cannot force the Bank of Spain to buy government debt. The ECB can provide all the liquidity of the world, but the Spanish government does not control that institution. The liquidity crisis, if strong enough, can force the Spanish government into default. Financial markets know this and will test the Spanish government when budget deficits deteriorate. This, in a monetary union, financial markets acquire tremendous power and can force any member country on its knees.
We've quoted at length here because we think this is a crucial difference, and one that still isn't widely understood. So despite similarities in their fiscal situations, the markets attach a much higher default risk to Spanish debt, and this is due to:
- The UK has a lender of last resort (the Bank of England), so it cannot really default while Spain's debt is issued in euros over which it has no control.
- When investors in UK debt sell, the money stays within the country (even triggering a devaluation which stimulates exports and growth, and therefore tax receipts and improves the public debt/GDP ratio). When investors in Spanish debt sell, the money leaves the country, worsening the liquidity crisis (and the banking system).
- Spain has no offsetting policy tools, like the UK.
Because of the mechanics of a monetary union, financial markets are much more powerful as money can leave the country at no exchange rate risk, sinking the economy further and there is no lender of last resort to back the Government debt.
The crucial point is this. Unlike countries that are masters of their own monetary conditions, in members of a monetary union, fears of default can easily feed on itself and don't automatically trigger any offsetting mechanisms.
When investors sell Spanish debt, they're likely to reinvest their euros not in Spain, but in German bonds (or bank accounts in Luxemburg). Spanish bond yields, liquidity, and bank balances (and therefore bank lending) suffer as a result, further undermining confidence, triggering further sell-offs and worsening economic conditions.
This negative spiral was already in an advanced state, with tens of billions of deposits leaving the Spanish banking system, and Spanish yields spiraling out of control. The resulting rising yields and shrinking economy makes fiscal consolidation that much more difficult. With only fiscal policy at its disposal, Spain itself is powerless to stop this. Indeed, many argue that the draconian budget cuts have only accelerated the process.
This is why the ECB has to stand behind the Spanish debt. It is the only institution that can break this negative spiral. There is simply no other way. Now, that doesn't mean there are no complications.
Some have pointed out to the anti-bailout clause as an obstacle. The anti-bailout clause explicitly forbids the ECB to buy debt in the primary market, but while buying bonds in the secondary market can be considered against the spirit of the Treaty, it isn't necessarily against the letter of it.
Yet, to be on the safe side, the ECB has couched its bond buying activities in terms of regular monetary policy, aimed at preventing a breakdown of the monetary policy transmission mechanism. And indeed, easing of ECB monetary policy doesn't seem to have any effect in the periphery.
One can, like Seeking Alpha contributor Colin Lokey has done, go over minute details of what exactly is the cause of the breakdown in the monetary policy transmission channel (whether bond spreads or deposit flight, as if these are not related), but this misses the point. Monetary policy isn't working in the periphery, and without the ECB doing something, the above negative spiral will run out of control sooner rather than later.
The reason for the anti-bailout clause is to separate fiscal policy and monetary policy. That is, it's designed not to provide a 'soft budget constraint' to politicians. Rising interest rates are a useful and effective signal for politicians to get public finances in order. But we have already quoted de Grauwe at length to describe that this mechanism is supercharged in a monetary union, and feeds on itself.
What's more, the only action politicians can undertake, cutting spending and increasing taxes, can very well worsen, rather than improve these dynamics. So we're not too worried to suspend this natural barrier for politicians under the present conditions in the likes of Spain, but only if it is replaced by something.
That something is Spain signing up for a bailout program with the European rescue funds (the temporary EFSF and the permanent ESM). The jury is still out whether Spain is actually prepared to do this, as it entails a loss of sovereignty and a loss of face.
Lokey concludes that:
I ask investors to again consider the fact that the ECB is more than willing to throw caution to the wind and step well outside of its mandate while justifying its actions with illogical assertions (breaking the rules to uphold them and implementing conditional uniformity). The ECB has, in my opinion, lost all credibility and before the crisis is over, I contend that this will cause the currency it prints to fall precipitously against its peers. As such, I believe circumstances continue to warrant a short position in the euro
We wholeheartedly disagree:
- Rather than throwing "caution to the wind and stepping outside its mandate," the ECB seems finally prepared to perform a function that is sorely missing in the eurozone, a lender of last resort. This is absolutely necessary as the ECB is the only institution that can break the negative dynamics that have thrown complete countries into a 1930s-style depression with no end in sight.
- Rather than losing "all credibility," we think that in conjunction with Spain signing up for an official bailout at the EFSF/ESM, this policy action of the ECB will enhance the credibility of the euro and its long-run survival chances. A first indication is that ever since markets got wind of these possibilities, the euro (which was slumping) has come back from its lows around 1.20 to the dollar to the 1.25 level.
- We are inclined to go long on the euro, although one should recognize that there are many banana peels on the road to euro salvation.