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As Eurozone squares up to quantitative easing, are fears justified?

German concerns about the European Central Bank’s impending quantitative easing program might be misplaced. AAP/EPA/Maurizio Gambarini

The European Central Bank is due to decide whether and how to undertake quantitative easing (QE) via large-scale purchases of government debt on secondary markets. For Germany - as the Eurozone’s largest economy and one with a decidedly conservative monetary stance - this seems to be the ultimate nightmare. But the markets are already betting that QE will come. With the Eurozone sitting close to deflation, the ECB must react to reach its inflation target of 2%. What are the German fears and do they withstand serious scrutiny?

Doesn’t QE lead to inflation?

Yes, and it should do so, namely bringing inflation back to the long-term objective of 2% to avoid the risk of deflation. According to ECB president Mario Draghi, the expected average inflation rate for the year to come stands at 0.37%. And for a ten-year period ahead it is only an average annual of 1.15%. So the ECB must act.

But will a QE program ultimately not bring much higher inflation? A look at the ECB’s balance sheet shows that monetary policy has been contractionary in the past years. In fact, the much talked about and not yet confirmed €1 trillion worth of debt purchases would just bring the ECB’s balance sheet size back to the €3 trillion it had reached already in 2012. A contraction of the central bank’s balance sheet was exactly what US economists Milton Friedman and Anna Schwartz believed was responsible for the great depression of 1929.

Thus, QE would be the medicine prescribed even by monetarist doctors. And if you are a true believer in the quantity of money as the long-term determinant of inflation; base money in the Eurozone has shrunk in the same period from €1.8 trillion to €1.2 trillion. The real danger is not a too large but a too hesitant QE program that fails to raise inflation expectations.

QE needs to be large scale and pre-announced until inflation expectations return to the normal level of 2%.

Isn’t QE forbidden government financing?

True, the Maastricht Treaty forbids government financing by means of printing money. But the QE program intends buying only on the secondary market. Therefore it is clearly within the mandate of the ECB. It is basically an open market policy directed at repairing the impaired monetary policy transmission when the interest rate is at the “zero lower bound”.

The problem with QE in the Eurozone is – unlike in the United States or the UK – that the ECB cannot buy a single sovereign bond to conduct an open market policy. Eurobonds do not exist. The suggested way to do QE in a “neutral way” is therefore to buy national bonds proportional to the equity shares of member countries in the ECB.

In the opinion of the Advocate General of the European Court of Justice (ECJ) proportional purchase of government bonds in secondary markets is in line with European law.

But QE will lead to fiscal transfers within the Eurozone

This commonly voiced argument is based on misunderstandings of how a currency union works. Economics professor Paul De Grauwe and Lecturer Yuemei Ji argue that when bonds are purchased proportionally, the immediate effect is that governments then pay interest to the ECB rather than to the public, which are then returned as ECB profits proportionally to the government. In fact, the taxpayer then saves money.

But what if, say, Italian bonds carry higher interest rates than German bonds? Under the current rules, the German taxpayer will make net gains as she receives more returned profits from interest revenues than she has paid. In this sense there is a fiscal transfer, but to the Germans. However, this transfer can be avoided by returning the interest payments to the bond issuer – but this would require to change the current rules.

But what happens if a country defaults? Not much! If the ECB wants to hold the bonds permanently this leads only to foregone revenues from redistributed interest payments. If the ECB wants to hold bonds only temporarily and at some point in time to reduce the size of its balance sheet, the question is whether it really needs to sell bonds of countries that default and thus realise the losses. This may be only necessary when several major countries would default simultaneously and even then it is questionable whether Eurozone governments need and want to recapitalise central bank losses. So the Germans can relax: careful design of QE can avoid fiscal transfers

Despite the previous arguments, it seems that Germany and other creditor countries would, if unavoidable, prefer that only national central banks buy their own countries’ government bonds to avoid the perceived risk sharing. While some argue it worth to compromise on this issue if this should be the price to get agreement to a large enough QE program, there is also a serious argument against it.

“Going national” could undermine the ECB’s credibility by signalling that the ECB cannot act in the interest of the whole Eurozone.

Well then, QE reduces the incentive to reduce government debts

Actually, QE helps public deleveraging rather than impairing it. Simple debt arithmetic shows that debt-to-GDP ratios grow even with zero deficits when interest payments exceed the growth of nominal GDP. With inflation close to zero and economic growth flat, growing out of debt is only possible with high budget surpluses, which increasingly meet political resistance – just look at Greece and France.

What about reducing the incentive to make structural reforms?

While this in fact might be true, it would indeed be better to postpone market liberalisation, which make prices more downward flexible when deflation is just around the corner.

Moreover, imposing or “only” incentivising structural reforms is beyond the mandate of a central bank. The opinion of the ECJ has made this clear: the Outright Money Transactions (OMT) program as such is not against the mandate of the ECB, but the fact that the ECB has conditioned bond purchases on an existing macroeconomic adjustment program.

Commitment to structural reform is a long-term political project that must be clearly separated from monetary policy making.

So, in summary…

QE will almost certainly come today. The issues are: will it be sufficiently large, sufficiently credible, and designed so as not to impair the long-term credibility of the ECB?

With an effective QE policy reducing government debts and modernising European economies will be not only be much easier – it will also contribute to give back the decisions on reform policies to where they belong in democracies: to the people that vote on it in elections.

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