It Seems QE Is Finally Coming to Euroland—Will It Matter at All?

When French president François Hollande pre-announced the ECB Governing Council’s long-awaited adoption of “quantitative easing” at its meeting tomorrow, German chancellor Angela Merkel was quick to respond by pointing out that this was still the independent ECB’s decision alone. It was good of her to do so. For in recent times one could not help getting the impression that the German political elite had forgotten all about that precious centerpiece of German monetary orthodoxy: that the independence of the central bank was the most important safeguard of solidity in the world.

Against the background of an ill-informed German public and an ideology-stricken German media landscape that excels in nothing more than keeping alive hyperinflation phobia even as the land of the euro is at acute risk of sinking ever deeper into the morass of deflation, Germany’s body politic got carried away with their self-righteous assumption that it was in everyone’s best interest to accept the reality of German hegemony over Euroland in all matters of economic policy, including monetary policy. Yesterday’s Financial Times quoted the former ECB governing council member Athanasios Orphanides on what would appear to be a rather intolerable (since illegal) state of affairs: “It is as if it’s accepted that the euro area’s modus operandi is to clear things with Germany, and for the ECB to constrain its actions to what is best for Germany … This is inconsistent with and violates the [EU] treaty.”

So if the ECB finally goes ahead tomorrow with some kind of QE, ignoring German resistance, what will QE actually do for Euroland?

Let’s briefly consult Keynes on this, who reflected on QE in his monetary writings as a means to directly influence financial conditions beyond the short rate set by the central bank anyway. Both in his Treatise on Money and in The General Theory Keynes distinguished two scenarios: whether the banks support the central bank’s efforts or whether the central bank has to go it alone.

In the first case, the impact on the central bank’s own balance sheet might turn out to be very limited as the banks’ purchases help moving long-term rates in the desired direction. What might prevent the banks from doing so? Keynes focuses on one obstacle in particular: the banks’ fear of future financial losses in case interest rates “normalize” again later on. This is a fundamental obstacle because if monetary policy turns out to be successful in overcoming the slump, a normalization of interest rates could be reasonably expected. In other words, there is an inherent time-inconsistency problem involved here. Keynes’s advice in the Treatise is that, if necessary, it is the authorities’ duty to ignore potential future losses of QE and do the utmost to overcome the crisis. The key additional insight offered in The General Theory is that the “long-period norm” (the level towards rates would tend to “normalize” again later on) is not fixed (or uniquely determined by those real forces of thrift and productivity), but itself a market convention that is subject to the expectations management of the central bank. If the central bank convinces the markets that yields will stay low for a long time, it may be the banks that carry out the purchases actually driving down the yields, and with little change for the central bank’s own balance sheet. By contrast, a “liquidity trap” scenario describes the case in which the central bank ends up going it alone, expanding its own balance sheet through asset purchases “à outrance,” while the banks prefer watching their liquidity rise instead as they are unconvinced that they would be able to carry the trade without future financial loss.

Keynes goes one step further in The General Theory, suggesting that the central bank could use an even more direct method of establishing “the” rate of interest it considers appropriate given the state of the economy, observing that “perhaps a complex offer by the central bank to buy and sell at stated prices gilt-edged bonds of all maturities, in place of the single bank rate for short-term bills, is the most important practical improvement which can be made in the technique of monetary management” (Keynes 1936, p. 206). His later war-time writings and outlook for the postwar era (featuring a huge U.K. public debt and foreign debts owing to the war efforts) followed this line of thought.

While it is generally accepted today that the central bank is the de facto monetary “central planner” setting the short-term rate of interest that anchors financial conditions, directly setting the whole term structure (and risk structure) of interest rates would be assured to run into trouble with what the Maastricht Treaty says about the requirement of economic policy to adhere to the principles of a “market economy.” So the ECB will have to restrain itself, directly setting only the short rate, but relying on expectations management – backed up by actual asset purchases (QE) if necessary – to steer financial conditions in the desired direction.

The remarkable thing is how far the “magician’s” successful expectations management alone has pushed yields and yield spreads down at this point, purely in anticipation of QE (given the unfolding deflationary economic environment). How much more can actual QE deliver at this point? Assuming that the ECB does not disappoint, and market expectations seem to be for a €500 billion program, I suspect rather little in terms of bond yields and spreads. If banks (and others) are tempted to offload to the ECB and take profits, is there going to be a big splurge into risky assets? In particular, are banks going to boost their lending to euro area SMEs, assuming that SMEs want to borrow more? The ECB’s latest Bank Lending Survey showed some improvement, but protracted demand stagnation and falling prices have created mounting balance sheet strains for the euro area private sector.

In the end, it will largely depend on whether the public sector is finally changing track and ends its insane austerity crusade. An important part of monetary policy lowering interest rates in a crisis is to prevent a rising interest burden from triggering counterproductive fiscal austerity. Lowering the public sector’s interest burden as such actually means reducing incomes. This can only be expansionary if falling interest rates encourage more spending overall. If the euro area fiscal authorities fail to use the windfall of a lower interest burden by embarking on something more constructive, a meaningful infrastructure initiative in particular, it will all come to nothing. In fact, add the insane idea of everyone becoming more competitive to the insane idea of everyone balancing their public budget, and the ECB can carry out QE until it is blue in the face without ever stopping deflation. In that case, QE amounts to one thing only: currency warfare! And Mr. Draghi’s words have been disturbingly effective in that regard too.

In short, QE per se is not a panacea for Euroland’s ills. What matters is whether Euroland will also end their other foolish policies or simply remain on track for “more of the same.” Note that Germany opposes QE for fear that it might discourage its euro partners from carrying on with the “more of the same” folly …