(This an edited version of my Sunday Business Post article from last week)
The ECB will start serious asset purchases in 2015, similar to the Securities Markets Programme it ran in 2010, but on a much larger scale.
This process is called quantitative easing—QE for short. QE has been fiercely resisted by hard money fanatics at the Bundesbank and the Finnish Central Bank, but it appears they have lost the battle to stop these purchases from happening. Their objections have been swept aside as fears of an outright deflation have taken hold.
Mario Draghi, the ECB’s President, has made the case for QE in a series of press engagements to alert the markets that this will be happening. In language that would bore anyone but a Central Bank watcher into a coma, but which for the usually elliptical Draghi was as clear as crystal, he said “We are in technical preparations to adjust the size, speed and compositions of our measures early 2015, should it become necessary to react to a too long period of low inflation”.
Translation: QE is coming, lads and lassies, and lots of it. Get ready.
But what is QE? Quantitative easing is an asset purchase scheme where the Central Bank uses its power to create money, and uses that money to purchase assets like bonds—which are just fancy IOUS—from insurance companies, pension funds, and private banks. That’s all it is. The swop of assets for cash increase liquidity on the insurance company’s (or whatever’s) balance sheet, making them more resilient to any crisis and more likely to push that cash out into the real economy.
The actual experience of QE has been very different in each country that’s tried it to date. Directly comparing the UK, US, Japanese and Eurozone versions isn’t a good idea. The best version has probably been the US version, which, if there was a textbook on QE, would be the textbook version.
QE has been mystifying the markets since it was first mooted as a possible solution to the economic crisis. QE is really useful where interest rates are very low, and where the economy still needs to be stimulated to grow its way out of a deep recession. Essentially when the central bank can’t use interest rates, it can still use the fact that it can expand both sides of its balance sheets massively to increase liquidity to help broken economies, and more importantly, banks broken balance sheets, to heal.
This injection of money into the system by the authorities also has the effect of increasing the price of the remaining bonds and so decreasing their yield. Prices of assets like equities and gilts increase, money is pumped into the banking system, and overall economic output should rise. The Bank of England calculated that the £200 billion of QE injected into the system between March 2009 and January 2010 probably raised the level of real GDP by between 1.5 and 2% relative to what might otherwise have happen, and increased annual CPI inflation by 3⁄4 to 11⁄2 percentage points. QE helped the UK get out of the worst economic crisis since the 1930s.
The problem for the average taxpayer is that they neither see nor feel the impact of QE on their lives, and I’ll come back to this point at the end. In the US, the UK, Japan, and most likely in 2015 across the Eurozone, QE caused large changes in the distribution of wealth, and some groups did feel the benefits. Pensioners, savers, and those with large financial portfolios all had what economists call an ‘income effect’, where the looser monetary policy reduced the interest payments paid by debtors and so increased their incomes, and a substitution effect where households could divert money they would have spent on servicing interest payments to other consumption. They saw large increases in their wealth, and in the US case, the economy saw lower real interest rates, higher inflation expectations and a lower U.S. dollar. A lower euro, in particular, as a result of large scale Eurozone QE, would be brilliant for Ireland.
So let’s think about pensions for a minute. Pension providers make up a large part of every institutional investor class in the world. They hold the assets whose prices are being effected by QE, and the pensions they issue to pensioners, like annuities, are similarly effected.
What about QE for the people? Mark Blyth and Eric Lonergan have put forward a plan in foreign affairs for central banks to give money directly to the people. Imagine waking up tomorrow and seeing an extra 500 euros in your bank account, similar to an unanticipated inheritance or tax refund. The direct effects on consumption, investment, and export activities would be very large-as well as progressive. This form of QE is radical, and untested, but if Europe’s oncoming deflation crisis worsens, it may be an innovation the ECB has to look at. Things really are that bad.
References
http://www.bankofengland.co.uk/publications/Documents/news/2012/nr073.pdf
Cook, D and J Yetman (2012): “Expanding central bank balance sheets in emerging Asia: a compendium of risks and some evidence”