19 September 2019
The Folly Of Euro QE.
Or a free lunch for bond traders
by Frank O’Nomics
It is one thing to use a sledgehammer to crush a nut but, once that nut is already dust, further bashing is a waste of effort. So it is with the ECB and its use of quantitative easing (QE). Just 9 months after announcing an end to monetary policy loosening, the ECB is at it again. Last week the deposit rate was cut further into negative territory, -0.5%from -0.4%, and the ECB announced that it would restart bond purchases (quantitative easing) at a rate of Eur20bn per month from November. With long bond yields already at unprecedented low rates, one has to ask – what is the point? More significantly, the right question is: will it do more harm than good?
In answering this it is important to understand just what the ECB is trying to achieve. They currently have an inflation target of close to 2%, yet the current level is barely half that and the economy is slowing – Eurozone output fell by 0.4% in July. With interest rates already at less than zero, the only monetary tool available to generate an economic stimulus would appear to be QE – the buying of huge amounts of government bonds, with new money. The hope is that those selling the bonds will invest the cash in other real assets thereby stimulating investment and growth. Bond yields will be driven down by the ECBs buying, thereby making the returns available elsewhere look much more attractive on a relative basis.
Does this work? Isolating the benefits of QE on economic growth is difficult to do, given that there are so many other factors at play – not least geopolitical issues. Looking at the performance of the major economies that have employed QE, one could argue that growth has been far greater than would have been the case without it, and the benefits for equity markets, as cash is reallocated from bonds, is hard to deny. However, an extended rise in the value of real assets is not the same as economic growth, and inflated house prices and stock markets are at odds with the low levels of GDP currently reported. The key questions regarding bond purchases are: whom are you buying them from? And what will they do with the money? Much of European QE will go into buying bonds from banks, who are either holding them as security against loans (and so will just have to buy other bonds, thereby forcing prices up and yields further down) or who have been holding inventory for the very purpose of selling them to the ECB – i.e., banks have been “front-running” QE, and will now be able to cash-in. In these cases the only benefit for the real economy, other than banker’s bonuses, is to drive long-term interest rates lower. However, very low current rates have done nothing to stimulate investment so far, and there is not sign that even lower rates will make a difference.
Properly targeted QE could still make a difference. Buying bonds of long maturities held by pension funds, rather than the shorter issues that are the held by banks, could prompt a greater increase in investing in businesses. Similarly, buying corporate bonds, thereby helping companies to fund themselves more cheaply by issuing more debt at lower interest rates, could bring even more direct benefit. However, there are limited amounts of both long dated government and corporate bonds that can be bought and hence most QE will be relatively ineffective.
On top of these issues one has to add the unintended consequences. The driving down of long dated bond yields has both reduced the returns for savers, and increased company pension fund deficits. Further, the situation creates a potential moral hazard for governments. The low cost of issuing long-term debt will encourage governments to borrow more, and this risks saddling future generations with unhealthy levels of debt, which will take ever-greater percentages of tax revenues to service. In fact, this may point to an underlying motivation of the ECB’s latest initiative. What they are effectively saying is that they are fast running out of ways that they can use monetary policy to generate an economic stimulus. The only way to kick-start activity then will be fiscal policy – cutting taxes and increasing spending.
There are a couple of additional reasons why we should question the re-opening of European QE. First, a significant proportion of the ECB did not want it to happen. Germany, France, and Holland account for over half of the region’s output and population, yet they (along with the likes of Austria and Estonia) voted against more QE. ECB President Mario Draghi, perhaps keen to act before handing over to Christine Lagarde, was only able to get has way by enlisting the support of the smaller countries within the EU. Secondly, Donald Trump supports the move. This is not just a standard reaction against anything that he says, but he is using the ECB to argue that the Fed should also be taking such proactive steps, and this leads us to the final key argument against the ECB’s move – wasting its firepower and thereby reducing its scope to act when there is a much greater emergency.
The true effects of QE may not be known for quite some time. Ahead of the process many would have expected the measures already taken to have had a much greater effect on inflation than has so far been seen. Perhaps the process takes a lot longer and, once the inflation genie is out of the bottle, the process could be hard to reverse. Alternatively, the whole process could be seen as an exercise in futility, that has unintended negative consequences that far outweigh the benefits.
