Quantitative easing for the eurozone: origin, impact and unintended consequences
By Prof. Dr. Freddy Van den Spiegel (Free University Brussels and Vlerick Business School)
This text is an extract of a more complete article from Freddy van den Spiegel. The full version is available on the CFS webpage in the Vlerick Policy Paper Series.
Quantitative easing is the ultimate tool for central banks, which is only used when all other tools, including extremely low or even negative interest rates, are not producing the hoped-for effect. That can be the case when the transmission mechanisms for monetary policy are not functioning or in case of a liquidity trap, when the general expectations are so pessimistic that low interest rates and ample liquidity cannot convince borrowers to take loans.
Quantitative easing consists of the central bank buying itself massively securities in a planned and openly communicated way. These securities, essentially government bonds and occasionally also private sector debt can be bought on the secondary and/or primary markets. Buying the bonds on the primary market, which means directly from the issuer, is called “monetary financing”. In that case, governments can finance their deficits without attracting investors as the central bank is just “printing” the money and buys the bonds. If these bonds are bought on the secondary market, governments have first to find investors in the primary markets, after which the central bank buys the issued bonds on the secondary markets. Also in that case, the financing of deficits is facilitated because the continuous buying of bonds by the central bank will drive the long term interest rate increasingly lower. Because of the strict legal framework in the EU, the ECB can only buy bonds on the secondary market (Treaty on the functioning of the European union, 2007, art 123). Quantitative easing can be one of the factors leading or increasing the pressure towards low or even negative interest rates.
Quantitative easing is considered to be a dangerous instrument for several reasons. It increases the supply of money in an artificial way, which could ultimately lead to inflation; it facilitates life for (public) borrowers, which could lead to more bad debt and insolvencies in the future; it distorts markets as it brings the interest rates to dangerously low levels; and the exit of quantitative easing is a very delicate operation, often leading to financial panic, as historical evidence demonstrates (Claeys, Darvas, 2015). The impact of QE is further analyzed in the next paragraph.
Many central banks started a QE program since the start of the crisis in 2008. The US central bank started its QE program already in November 2008, ended its buying program in October 2014 and is now discussing the exit strategy. The ECB only started its QE program in March 2015, called the Public Sector Purchasing Program (PSPP), which consists of the commitment of the Eurozone central banks to buy every month 60 billion € public bonds, until September 2016.
Effects of Quantitative easing
Quantitative easing is a powerful instrument, with lots of direct and indirect effects, some of them intended (or positive), some of them unintended (or negative effects). Some of these effects materialize in the short term, others more in the medium to long term. Figure 1 gives an overview of these effects.
There is a direct impact on short and long term interest rates, depending on the assets that the central bank buys. When interest rates are already very low, this impact can be negligible, but nevertheless real.
More money in circulation and the fact that there is more demand for specific securities facilitates directly borrowing for those issuers, even if the central bank is buying bonds on the secondary markets.
The announcement of QE can have an immediate downward effect on the exchange rate of the currency, as the outlook for investors deteriorates. Lower exchange rates improve external competitiveness and exports. Clearly, the announcement of QE for the Euro supported the depreciation of almost 20% of the Euro/Dollar rate.
As QE creates plenty of new liquidity, the immediate risks for market crashes is reduced.
Risk premiums in general come down, as low interest rates push investors to take more risky assets in order to get an acceptable level of return.
The increased money supply, together with the financial repression of sometimes negative interest rates, and the outlook for increasing inflation later on, can stimulate immediate demand in the real economy.
There are also short term negative effects such as the fact that QE distorts the normal functioning of markets, depending on the amounts and the specific markets where securities are bought by the central bank.
Furthermore, artificially lower risk premiums can also be an indicator for growing bubbles.
In the medium to long run, there are no specific positive effects of QE, unless it has an impact on the recovery of the economy and leads to sustainable long term higher growth. Central banks, and especially the ECB is however warning against this hope: QE can give a short term positive shock to the economy, but has to be accompanied by “structural reform” in order to have a sustainable effect.
The potential negative effects of QE in the medium to long term however are very clear.
Institutional investors such as life insurance companies and pension funds run the risk of insolvency, as the return on assets can get below the contractual return on long term liabilities.
QE continued over a longer period of time makes life for borrowers (too) easy. Especially governments can take the advantages without continuing the necessary and difficult structural reform of the economy to improve structural competitiveness. In that case, QE is only increasing the problem of excessive debt and bad loans.
If QE leads to bubbles in some asset real or financial markets, the risk of crashes increases with time.
Lower exchange rates support international competitiveness and export, but will also lead to reactions of other currency zones if they consider the lower exchange rate as an unfair instrument of competition. Currency wars can be a consequence.
Finally, the decision to end the QE, somewhere in the future, and defining the path to normalize the situation is a politically very sensitive process. There will always be analysts in favor of exit as soon as the first signs of recovery appear, in order to avoid inflation to increase too much. Others will be more in favor of waiting because an early exit could jeopardize the recovery.
From this overview can be concluded that QE delivers a broad range of short term advantages to promote economic recovery. However, the longer the QE takes, the more important will be the medium/long term effects which are essentially negative. In other words, QE seems to be a shock therapy to the economy which should not take too long. It is certainly not a fundamental solution for structural problems underneath the deteriorated economic situation.
Scenario’s for the future
Many scenarios can be imagined about how the Eurozone will get out of the QE phase. Essentially two are discussed below: one in which QE together with the other interventions are successful, and one in which the cocktail of policies, including QE, is failing.
Scenario of successful QE
The most optimal outcome of QE for Europe is that the actual signs of recovery of the economy become gradually stronger, until growth gets higher than 1,5% (the actual forecast of the commission for 2016). EU initiatives like the Juncker plan, help this recovery based on sustainable long term finance. The weaker Member states continue successfully their structural reform and confirm the actual improvement with gradually reducing government debt and a positive current account. Meanwhile, the EU legal and governance framework is further strengthened, with more discipline and coordination of economic policies of Member states and more EU money available to intervene in case of unexpected problems. Interest rates can be kept low for an extended period, as inflationary pressures remain subdued. The debt levels are stabilized, which means that they come down as a percentage of GDP. The financial system is further reformed, with a smaller banking system and more financial market activity. Fears that QE will lead to excessive inflation and bubbles do not materialize: after all, the supplementary volume of debt from QE is foreseen to be 1600 bn €, less than 5% of the existing debt levels. As the economy gets stronger, the ECB gradually starts an exit from QE. That can be done in an “automatic” way by not renewing ECB investments in government bonds when they come at maturity, or even more aggressively by selling government bonds in order to reduce available liquidity.
This almost sounds like a fairy tale, and indeed, it requires a lot of conditions to be fulfilled, but it is not impossible, even if parts of the puzzle are only partially realized.
What if QE is not successful?
It can of course not be excluded that the economic outlook for the Eurozone is not improving, despite QE, but that the EU and the Eurozone is just muddling through or is even confronted with new shocks and problems such as recession, political disputes and/or a renewed financial crisis. If QE, being the ultimate tool for monetary policy of central banks, is not able to produce the hoped-for results, other instruments of economic policy can still be implemented, going from capital controls, wealth taxes, some member states leaving the Eurozone, nationalization of parts of the financial system (such as banks), to even additional failing member states requiring help from the IMF.
As all possible policies under this scenario are far more intrusive and disruptive than QE, we can only hope that they will not be needed.
Since the crisis of 2008, the EU and more specifically the Eurozone is in a bad shape. As the home region for an extremely large banking sector, the effects of the banking crisis were far more severe than in other parts of the world and were even threatening a number of Member states. As there was no political framework available to stabilize these weaker member states, the banking crisis became a sovereign crisis in 2011, threatening the single currency. A policy framework to manage this crisis was gradually developed, consisting of more discipline among member states, a (partial) banking union and mechanisms to resolve problems with European funds. But in the meantime, the economy did not recover, the levels of debt increased and the monetary policy instruments used were gradually extended.
The ECB is now implementing its ultimate tool, quantitative easing, which also the US and many other countries have used since 2009. QE remains controversial because it is not part of the conventional toolbox of central banks and history shows that “printing” money to finance the short term problems often leads to more serious problems in the long run. However, there is no valid alternative, and the experience of the US is rather encouraging.
QE alone will not bring a fundamental solution, but if it is combined with the necessary structural reforms at Member state and Eurozone levels, as planned, it can provide the necessary oxygen for a certain period of time to facilitate the reforms.
- Bank for International Settlements (2010) “Basel Committee on banking supervision: Basel II, a global regulatory framework for more resilient banks and banking systems”.
- Buttiglione, L., Lane, P., Reichlin, L. Reinhart, V. (2014) “Deleveraging? What deleveraging?, Geneva reports on the world economy, CEPR – ICMB
- Claeys, G, Darvas, Z. (2015) “the financial stability risks of ultra-loose monetary policy” Bruegel.
- Draghi, M. (2012) “Speech on 26 July 2012, at the Global Investment Conference in London”
- ECB (2014) “ECB announces monetary policy measures to enhance the functioning of the monetary policy transmission mechansm”, Press release 5 June
- ECB (2014) “The ECB’s forward guidance” ECB Monthly bulletin, april 2014.
- ECB (2015) internet site, chapter “monetary policy”, “instruments”.
- Federal Reserve Act, (1977).
- Hubbard, G., O’Brien, A. (2014) “Money, Banking and the financial system”, Pearson.
- Kindleberger, C. (1996) “Manias, Panics and Crashes”, Wiley.
- Minsky, H. P. (2008) “Stabilizing un unstable economy”, McGrawHill.
- Summers, L. (2013) ”Secular stagnation” speech at the 14th IMF Annual research Conference, Washington DC, 8 November
- Treaty on the functioning of the European Union, 2007.