The European Central Bank announced on Thursday that starting in March it will purchase 60 billion euros a month until at least September 2016, and that purchases of sovereign debt will be based on national shares of ECB capital.
European Central Bank President Mario Draghi announced the measure, which is intended to boost growth and inflation, at a press conference in Frankfurt.
The ECB is adding 1 trillion euros to its balance sheet, in a process known as quantitative easing, just after the Federal Reserve wound down six years of bond buying in the United States. England and Japan have experimented with versions of QE in the past, too. But the ECB isn’t entirely new to the bond-buying scene. The bank has already been buying up private securities. The difference is that now the ECB is going after sovereign (i.e. government) debt, and they’re printing money to do it.
What Is QE?
QE works, in theory, like a chain intended to pass on reduced borrowing costs: Central banks print money to buy other institutions’ debt. That cash infusion cheapens the cost of credit for those institutions, allowing them to lend to businesses and consumers, who hopefully will invest, produce and hire more. It’s all in the name of stimulation; get the economy going by passing a (newly minted) buck (or euro) on to other lenders. QE also further weakens the euro, making European businesses more competitive outside the eurozone. Already Thursday, the euro fell more than 1 percent against the dollar to $1.1453.
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For the ECB, QE is a measure of last resort. It has already tried the other instrument in the standard-issue central bank toolbox: cutting interest rates. The ECB slashed rates to below zero, lower even than the Fed Funds rate. But whereas the Federal Reserve has a dual mandate to stabilize prices and maximize employment, the European Central Bank has only one mandate. And on that, they’re failing.
The Threat of Deflation
The bank’s sole job is to keep inflation at roughly 2 percent — about the same as the Fed’s target in the U.S. In December 2014, inflation in the eurozone was -0.2 percent. Cue deflationary worries.
Deflation is bad for businesses because falling prices don’t incentivize companies to produce. It’s bad for banks, too, because borrowers with falling incomes are more likely to default since the real interest rate they’re paying goes up as deflation takes hold and the value of money actually increases. (Paying back an 8 percent auto loan is a lot easier when you’re paying back in dollars or euros that are worth less and less.)
Deflation may be worse still, as Benn Steil, director of International Economics at the Council on Foreign Relations explained: falling prices seep into consumers’ psyches. In other words, if consumers are so accustomed to sinking prices that they expect prices to drop even more, they’re going to hold off on buying. “This is why Draghi has a real sense of urgency to act,” said Steil, “before deflationary psychology sets in.”
Getting to this point has been a slow road for Draghi. In 2012, his comments that he would “do whatever it takes to preserve the euro” — without actually ever acting — were enough to buoy markets, and earned him the nickname “Super Mario.” Although he hinted last June that he was interested in expanding purchases beyond private assets, he’s had to be careful, said Steil, to placate the Germans, whose cooperation is essential to the sustainability of the eurozone.
A Delicate Political Balance
The Germans have reason to be concerned for the simple reason that, unlike the Federal Reserve, the eurozone does not issue its own bonds. Instead, it must deal in the sovereign debt of 19 different national banks. That means that when the ECB takes on government debt, especially from countries like Spain, Italy and Portugal, there’s a risk of default. Germany wants nothing to do with other countries’ debt, Steil said.
Therefore, under the compromise approved by the ECB governing council, the national central banks of the eurozone countries will undertake 80 percent of the risk of the bonds that they and the ECB buy.
While that decentralized approach to QE may send mixed signals about eurozone unity, Steil said, it’s worth it if it precludes Germany from mounting some bigger challenge to QE. “It’s the best Draghi could do,” he added.
Will It Work?
The best won’t necessarily work, however. In fact, Steil predicted QE may be less effective in Europe than in the U.S. Selling bonds to the market, Steil said, is how U.S. companies borrow. But in Europe, traditional bank lending is a much bigger source of commercial financing, and given all that the banks have endured during the financial crisis, they’re not all eager to expand their balance sheets by passing the new money on to borrowers.
So even with lower borrowing costs, banks and companies — if they don’t feel the demand — might not lend. “You can lead a horse to water,” he reminded us, “but you can’t make it drink.”
But suppose the banks do drink. Because some of the investments resulting from reduced borrowing costs will end up in the stock market, QE will be accused, especially in the Piketty era, Steil said, of exacerbating inequality. That’s the reality of a stimulatory tool that works through capital markets, he said. In the long-run, though, the hope is that everyone — the rich and the poor — will be better off if deflation is averted.
Just how much it can be averted is up for debate, though. “If people believe prices will be lower in the future, then the ECB has a real problem,” Steil said.
“What the ECB would really like to do,” he added, “is encourage banks to make loans to companies and for companies to borrow more money and hire more people.” An indirect way of doing that — cutting interest rates on loans to commercials banks that promise to lend to companies and individuals — is included in Thursday’s policy announcement.
But getting companies to borrow and hire is easier said than done within the confines of the ECB’s toolbox, especially now that rates are already at the zero lower bound and inflation is so low. “We’re all experimenting,” Steil concluded, “in unfamiliar territory.”