The ECB has pulled the trigger, but will the bazooka blow?

25 Jan 2015 | Author: | No comments yet »

Draghi’s bazooka will not raise eurozone from dead.

In the rush to get the economic headlines of the day, it can be hard to get a sense of what a development really means. After dragging its feet for the past five years, the European Central Bank has finally placed its ultimate policy bet with a government bond-buying programme designed to pump €1 trillion (HK$8.7 trillion) of new money into the deflated euro-zone economy. Only one thing is certain about the apparently open-ended programme of quantitative easing promised on Thursday after months of ECB infighting; although quite a bit more ambitious than expected, in itself it won’t do the job, or anything close.

Will this stimulus proceed like it did in the United States where most of the funds went into the “financial circuit” and very little going into the production of goods. Europe’s new program of money printing — and the resulting fall in the euro — means the US economy must deal with a rapidly strengthening dollar that will make American goods more expensive abroad. The stronger dollar could slow both US growth and inflation, giving the Fed some incentive to hold off on its plan to raise short-term interest rates later this year from near zero.

On Thursday, the ECB announced a package of security purchases that could total at least €1.1 trillion “in a bid to spur growth in the eurozone and countering deflation.” “The single currency had fallen through the $1.13 and $1.12 marks by midday, dropping more than 2 per cent against the dollar to $1.111 its lowest since 2004.” Mario Draghi, president of the ECB, wants to spur on domestic purchasing in the eurozone and also increase exports from the eurozone – both of which, he hopes, will keep Europe from declining into another recession and help to stop the deflation in the eurozone and renew price inflation. US officials have been playing down that scenario, and, more broadly, resisting talk of a global currency war — competitive devaluations by countries eager to keep their currencies as low as possible to protect exports. The US dollar has already soared in the wake of the announcement by the ECB to launch a €60 billion-a-month bond-purchase program, known as quantitative easing or QE.

As the demand for those bonds increases, prices rise, and interest rates fall – which, ideally, creates a ripple effect that means banks are more willing to lend, and borrowing is cheaper for everyone. QE, for short, is considered an unconventional form of monetary stimulus for when interest rates can’t go any lower, and lending simply isn’t picking up. Draghi during most of 2014, analysts and investors were not totally sure that he wanted to go into quantitative easing and that if he did move in that direction, the program would be on the tepid side. The program has had a high profile in recent years: the U.S., the U.K. and Japan have all used bond-buying to stimulate their economies, with mixed results.

The announcement has long been anticipated, and many noted it had been priced into the market already, so the surprise this week was not the program itself but its size. Among the factors driving the rise has been the US economy’s strong performance amid a slowing global economy, as well as signals by the Fed of a likely rise in interest rates this year. Since the financial crisis erupted six years ago, Western economies have leant heavily on their central banks to dig them out of the mess they are in. There is nothing wrong with monetary activism as such, but to believe it a panacea is to descend into fantasy, and it has now almost certainly reached the limits of its usefulness. It seems everyone has an opinion on this – and the main issues are the differences between the eurozone economy and the U.S. and U.K. economies, political division over how the risks should be shared, and reservations about whether QE is a band-aid to patch over badly-needed structural reforms.

The Fed was quick off the blocks to embrace quantitative easing, more than quadrupling its assets in the space of five years through its bond buy-back programme. Short of “helicopter drops” of free money, a policy which would amount to outright debasement of the coinage, there is little more that monetary policy can do. It delivered a huge amount of cheap cash to consumers, businesses and investors, helping to spark economic recovery and hard-pressed financial markets to rally.

With everyone now at it, race-to-the-bottom, competitive currency devaluation has become a zero sum game that, intuitively, we all know is likely to end badly. In any case, German aversion to use of the central bank printing press means the eurozone has been slow to join the party, and may already have missed the boat. Bizarrely, given the euro zone’s dire economic circumstances, the ECB turned the other way, allowing its balance sheet to shrink by about a third in the past three years, squeezing credit hard and leaving recovery to wither on the vine. There’s been a lot of political division within the eurozone over the use of QE, particularly from Germany: the German central bank’s president has probably been the loudest critic, particularly of creating a program where risk is taken equally by every country.

This isn’t surprising – Germany’s bank is both known for being particularly conservative, and the German economy is much stronger, and therefore less risky, than Spain or Italy. The bank estimates prices for US imported consumer goods were down 1.7 per cent in January from a year earlier, a move its analysts said was associated closely with the stronger currency, which holds down the price of imports. Thankfully, the ECB has left its strategy open-ended, promising to keep its quantitative easing coffers open until deflation is defeated and a sustained upward adjustment in inflation is achieved. It’s a compromise, and there’s criticism (including from the IMF) that this could dent the credibility of the program: after all, the eurozone is supposed to act as one.

Given severe headwinds posed by biting government austerity cuts, it would be no surprise if the ECB’s balance sheet ultimately rose above €5 trillion in the next five years. The other, time-old criticism is that the eurozone’s problems are structural, especially in terms of the strength of exports and the labour market, and QE alone simply won’t fix those problems. Part of the point of QE is to push the euro down and therefore spur exports, but countries still have to compete in other ways to make their products attractive around the world. All of these worries come down to one kicker: QE is usually a last resort, and there aren’t really any other weapons left in a central bank’s arsenal if it doesn’t work.

Belief that the fast-devaluing euro will provide a life-saving boost to European exports and a surge in free-spending tourism is similarly just wishful thinking. Many US officials say privately they prefer a strong European trade partner — even at the expense of some exports — to a weak Europe with associated risks to global growth and financial stability. The trouble is that, having decided on a common currency, Europe has failed to develop the collective approach to fiscal policy needed to make it work. Crisis has been almost deliberately courted in the hope of driving structural and fiscal reform, but it has only succeeded in giving voice to radical populists, from Greece’s Syriza to Spain’s Podemos.

Ultimately, the real argument for QE is the hope that that promise leads to confidence, and that confidence proves contagious, getting banks lending again, and Europeans spending.

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