The ECB has no alternative to enacting some form of Quantitative Easing (QE) in order to prevent deflationary expectations from setting in fully. Core inflation has already reached a level that, even according to Mr Draghi’s own pronouncements on 24th April, should have already triggered off QE. (See also Wolfgang Munchau’s well argued case here.) However, the ECB’s governing board is finding it hard to agree on what assets the ECB ought to buy. In this post I suggest a simple answer to this debilitating question.
When the Bank of England contemplated QE, there was never an issue of what it ought to purchase: UK bonds and various assets belonging to UK based banks. Similarly with the Fed: US Treasuries and an assortment of debt instruments owned by Wall Street. But the ECB?
There are two issues the ECB faces: (1) The operational/legal problem, and (2) the macroeconomic concern.
1. The ECB’s Operational Problem
What should the ECB buy? If there were eurobonds, the ECB would have begun by purchasing eurobonds, just like the Fed bought Treasury Bills. However, in the absence of eurobonds, should the ECB go for German or Italian bonds? Spanish or Dutch paper assets? And how would this purchasing portfolio be structured in a manner that does not stir up accusations in Berlin that the ECB is indulging in underhanded monetary financing of member-states or of national banks? This is what I call the ECB Operational Problem. From a macroeconomic point of view, it is an inane problem; a legalistic and political impediment to a policy whose time has come. Still, one ought to refrain from underestimating legalistic impediments to necessary policies, at least when it comes to the New Byzantium – also known as the European Union.
2. The Macroeconomic Concern
The British and American experience has taught us that QE is, as Keynes had warned, a little like pushing a hanging string from below: ineffective relatively to the exerted effort and cost. Moreover, by purchasing paper assets that are many ‘removes’ away from the real economy, the result is to reflate bubbles that are better left deflated, in the hope that the money made by those fortunate enough to benefit from these bubbles will trickle down to the rest of the social economy. In the United States and in Britain we have observed that, while this newfangled version of ‘trickle down’ has helped stem deflationary expectations (which is a good thing, of course) it has, at the same time, failed to turn idle cash into productive investments – of the sort that can create meaningful jobs that produce meaningful goods and services.
The ECB’s current thinking
From what one hears and reads. the ECB is very coy about QE primarily because of the ‘operational problem’ above, with some ECB governing board members mentioning the ‘macroeconomic concern’ as an added reason to be cautious. In response, the ECB is moving toward another interest rate cut (even though there is extremely little downward room to do this) and, possibly, a negative interest rate for money that banks ‘park’ with the ECB. Also, Mr Draghi seems keen to reinvigorate the structured derivatives market in Europe, effectively creating new CDOs that bundle together loans to small and medium sized (SME) firms from the European Periphery – which CDOs the ECB will then purchase in the hope that this will reduce the interest rates that Peripheral SME’s pay. It is highly unlikely that any of these three steps (interest rate cut, negative deposit rate and the revival of European SME-debt based CDOs) will have any appreciable effect on the juggernaut of deflationary expectations.
A Modest Proposal (*)
- Europe desperately needs growth-inducing, large-scale investment.
- Europe is replete with idle cash too scared to be invested into productive activities, fearing lack of aggregate demand once the products roll off the production line.
- The ECB wants to buy high quality paper assets in order to stem the deflationary expectations that are the result of the above.
- The ECB does not want to have to buy German or Italian or Spanish assets lest it it accused of favouring Germany or Italy or Spain etc.
Here is what the ECB could do to achieve its objective while overcoming both its ‘operational problem’ and the ‘macroeconomic concern’ above:
- The European Investment Bank (EIB) and its smaller offshoot the European Investment Fund (EIF) should be given by the European Council the green light to embark upon a Pan-Eurozone Investment-led Recovery Program to the tune of 8% of the Eurozone’s GDP, with the EIB concentrating on large scale infrastructural projects and the EIF on start-ups, SMEs, technologically innovative firms, green energy research etc.
- The EIB/EIF has been issuing bonds for decades to fund investments, covering thus 50% of the projects’ funding costs. They should now issue bonds to cover the funding of the Pan-Eurozone Investment-led Recovery Program to the full; i.e waving the convention that 50% of the funds come from national sources.
- To ensure that the EIB/EIF bonds do not suffer rising yields, as a result of these large issues, the ECB ought to step into the secondary market and purchase as many of these EIB/EIF bonds as are necessary to keep the EIB/EIF bond yields at their present, low levels.
Notice that Step 3 means that the ECB enacts QE by purchasing… eurobonds; as the bonds issued by the EIB/EIF are issued on behalf of all European Union states. Thus, the ‘Operational Concern’ is obviated.
Notice also, that this form of QE backs productive investments directly, as opposed as by first inflating some financial bubble (or having to re-create a suspect CDO market, as per Mr Draghi’s current intentions). This way the ‘Macroeconomic Concern’ is dealt with and Europe avoids pushing on the proverbial string.
Lastly, to deal with the objection that the EIB/EIF belong to all 28 members of the EU, whereas the Eurozone is only a subset of 18 member-states, the simple answer is: The above EIB/EIF program only needs to apply to projects that fall within the Eurozone and, importantly, the ECB purchases of EIB/EIF bond issues that relate to these Eurozone-specific projects. If, however, some non-Eurozone member-state wants to partake in the Investment-led Recovery Program, its own central bank could come to a bilateral arrangement with the EIB/EIF so that the said central bank (e.g. the Bank of England) may include into its own QE portfolio purchases of the specific EIB/EIF bond issue related to the funding of projects in that country.
(*) This proposal is part of our broader Modest Proposal for Resolving the Euro Crisis – see Policy 3
