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The ECB and QE in the Last Chance Saloon

8th December 2014

It has become increasingly clear in the last week or two that the ECB is on the cusp of launching its own version of QE – finally. It would be good to feel more enthusiastic about it, having been a QE cheerleader since the Euro crisis began. Sigh. QE should indeed have happened a long time ago. It was never going to suffice on its own to restore the Eurozone to economic health, but its impact now is likely to be significantly less. And if Brussels and Frankfurt really think that bank lending to SMEs is a significant reason for the funk in lending, QE will be a poor relation to the speedy and significant recapitalisation of banks, accompanied by measures to consolidate the densely populated banking sector. The October AQR and stress test looked like a missed opportunity then, and even more so  now.

Screen shot 2014-12-08 at 18.33.25

Source: ECB

Sadly, QE almost feels like a bit of an irrelevance. It is a kind of last chance saloon for Europe to try and fix a monetary union that has history, political support and policy-making stacked against it. There has never been a successful monetary union that wasn’t preceded by political union. European citizens increasingly regard European institutions, including the ECB, and processes with apathy or the reason to support populist and anti-EU political parties. (Let the next generation speak up for Europe by Timothy Garton Ash captures some of this well Where Europe needs activist policy-making – in the areas of fiscal management, infrastructure (For a good discussion about the toothless Juncker plan, see Frances Coppola, Juncker’s CDO,, and debt relief, and the kind of structural reforms that enhance debt sustainability – effective decision-making is as quiet as the Night before Christmas.

These matters will preoccupy us in 2015 as well, but for now, let’s just dwell a while on the QE, which is now in the ECB’s crosshairs. Expectations by the Council regarding the ECB’s balance sheet size have become intentions. Vigilance and vagueness have been elbowed in favour of a commitment to consider buying ‘other assets including sovereign bonds in the secondary market’ early next year. Consensus is for an announcement at the Council meeting on 5th March, but it could happen at the first meeting on 22nd January.

A lot of people are champing at the bit at the prospect, based on past experience of  central bank asset purchases and the Pavlovian response in equity and other financial markets. If the words don’t, count, chickens, and hatch come to mind, perhaps you think, a little like me, that the ECB’s QE is likely to be compromised, and ineffective.


Two catalysts have spurred the ECB into more decisive thinking on QE. First, the collapse in inflation (see chart below) and inflation expectations, and the wider dispersion of deflation among member countries and within the HICP indices of all member countries. The ECB’s own Survey of Professional Forecasters, released on 13th November, showed inflation of just 0.7% at the end of 2014, rising to 1% in 2015, 1.4% in 2016, and 1.8% in 2019. And these predictions are most likely based on an assumed return to an equilibrium in the Eurozone economy, which may no longer exist. If aggregate demand in the Eurozone remains as it is, these forecasts will prove optimistic. In any event, the forecasts and the ECB’s latest thinking pre-date the most recent sharp falls in the price of crude oil. By itself, this wouldn’t necessarily be the deflationary risk that many economists seem to think it is. But it is a problem in the context of the Eurozone’s existing proclivity to deflation as a result of inadequate aggregate and a still dysfunctional banking system.

Screen shot 2014-12-08 at 17.07.56

Source: Eurostat

Second, disappointment about the capacity of covered bond and asset backed purchases and targeted LTRO’s – so far – to expand the ECB’s balance sheet back towards the €3 trillion or so that prevailed in early 2012. In the first two weeks of the programme, the ECB bought about €8.1 billion of the former, and about €600 million of the latter. The next TLTRO auction on 11th December may exceed its predecessor’s paltry €82.6 billion, two 3-year LTRO’s, valued at €276 billion will roll in the first two months of 2015, and covered bonds and asset-backed purchases could pick up momentum after a slow start. Yet, there remains a strong feeling that these will fall well short of the ECB’s €1 trillion balance sheet increase objective.

Vice President Constancio warned a couple of weeks ago that early next year the Council might have to consider buying other assets. These would certainly include purchases from the €9 trillion pool of sovereign bonds, the €1.5 trillion of corporate bonds (though a markedly smaller pool, having regard to credit risk) and the near €500bn of EFSF/ESM, EIU and EU bonds (though probably larger if EIB issuance expands in line with the Juncker infrastructure plan proposals).


But what should we expect from the ECB, bearing in mind that by all accounts, the embrace of QE has been much less than unanimous. According to some reports, half the ECB’s Executive Board ( Lautenschlaeger, Mersch, Coeure) are not in favour, and while the Council itself has a built-in majority for QE, there’s no question that its opponents can make a lot of noise. In Germany, especially, they are likely to bring pressure to bear on their own government, and via the Constitutional Court, which has already passed a decision on OMT’s to the European Court of Justice.

It is hard to gauge the depth of the divisions within the ECB, let alone assess if they go far enough to make QE a resigning issue for Executive Board or Council members. If Mario Draghi, said in parts of the German press to be increasingly frustrated by the orthodox financial establishment in Germany, didn’t or couldn’t get what he really wanted, could he be the fall guy, and head back to Rome for a top political post? We shall have to see how ECB politics play out, but the fact that these matters merit a mention in the first place casts doubts about the nature of the QE programme that may be forthcoming.

All things considered, it is doubtful that Eurozone QE will resemble its US, UK and Japanese predecessors. So for reference, with central bank assets as % GDP:

Screen shot 2014-12-07 at 18.59.00


The US did $4.5 trillion of QE over five years, lifting its asset holdings from about 5% to 25% of GDP. The Bank of England did £375 billion, pretty much matching the Fed. The Bank of Japan started off at a significantly higher level of assets to GDP, but is set to double them to about 70-75% of GDP by next year. By contrast, the ECB’s balance sheet is barely higher now in terms of GDP than it was before the GFC, though as stated, it had been up at about 30% GDP in early 2012 – a level to which it wants now to return.

ECB likely to be much more constrained and less effective. How so?

In the first place, dispute and division are likely to result in compromise. QE is quite likely to be limited to a modest fixed amount, and to a limited period of implementation, say up to two years.The amount could be limited to the €1 trillion increase in the balance sheet which the ECB has stated it wants, but bearing in mind other asset programmes and the ‘monetary financing’ stigma of sovereign purchases, the amount could be lower, say 500-750 billion. This would compare with the nearly €2 trillion of sovereigns it would have to buy if it were going to match the efforts of the Fed and the Bank of England. No one knows what the numbers will be but note these perhaps for reference.

Second, the sovereigns would be bought according to the ‘capital key’, which assigns weights to each member in accordance with their contributions to the ECB’s capital. But almost half the bond purchases would be Germany and France, because some members have little or no marketable debt,  while others such as Greece and Cyprus are still in troika programmes. So, given illiquidity and or token purchases, it is likely that the weights of the stronger and more liquid countries will be reweighted to reflect these issues. Other than Germany and France, Italy and Spain might account for about 30%, Holland and Belgium for 10%, and Portugal, Austria, Finland and Ireland, for most of the remainder. The real benefit of QE in Europe should accrue to the periphery by overweighting its purchases, but this cannot, and will not be allowed to occur.

Third, the ECB is leaving all this very late. Deflationary momentum and depressed aggregate demand have already resulted in Bund yields falling to 0.7%, with sovereign spreads tightening across the board (mostly). QE speculation has been running for long enough for the market to be long, and overweight periphery sovereign debt. It isn’t clear, therefore, how significant the initial or subsequent market reactions will be to a QE announcement, but we shouldn’t expect yields to drop that much – maybe 20-25 basis points for Bunds and core Europe, a little more elsewhere – at most?

Fourth, QE really seems to have one transmission route, the exchange rate, and even that can be overstated. Consider that

  1. the direct interest rate impact on government bonds will be small, assuming it’s positive
  2. banks are more likely than not to replace purchased assets with excess reserves. It would be nice to think that corporate yields would fall a bit further, but this mecahnism is far less significant than it is in the US and UK, where capital market funding is of much greater importance
  3. debt relief or cancellation, or any other form of helicopter money for the periphery is ‘verboten’

Consequently, the EUR is the most likely route for the ECB to reverse deflation. The example of Japan is often cited, but the Yen was significantly overvalued at $/Y75, when the slide began, and the market was nowhere near as short as it is vis-a-vis the EUR today. Plus, the Euro Area has a current account surplus now of about 3% GDP, larger than that of Japan. So, Europe is going to have to try really hard to get the EUR down to levels, say 1.10 against the US dollar or even parity, that would make a difference to the HICP rate, inflation expectations and Europe’s economic prospects. The good news is that the Europeans are knocking on an open door, given that the US economy and prospective Fed policy are conducive to a stregthening US dollar. But that said, the ECB would need to implement a QE programme significantly bigger and stronger than what is suggested here. Even then, it is highly questionable whether a further 15-20% depreciation of the EUR would have a more significant impact than Japan’s 50% depreciation has had on its economy. And Europe is three times as big in terms of US$ GDP.

And so….

Maybe Mario Draghi should recite Macbeth’s famous pondering to his Council colleagues, and to the Executive Board, including the key lines,

If it were done when ’tis done, then ’twere well 

It were done quickly     

Or, to coin a phrase, just do it (QE) and do it in size, and do it with panache. But it won’t happen this way and anyone expecting the ECB to have the same sort of impact as the Fed and BoE did initially, aided and abetted by forceful and early bank recapitalisation and the tailwind of fiscal stimulus, is going to be disappointed. Some things – like the need for QE to be linked up with debt relief, fiscal stimulus, structural change, and bank recapitalisation and reorgansiation don’t change. Some things, such as the growing fragmentation and nationalism in European politics, do – and are, possibly starting in 2015 with Greece and Spain.