19 January 2015

There are several reasons why ECB Quantitative Easing (QE) will have limited economic impact.

Eurozone remains dependent on bank lending

The ECB has already injected €1 trillion worth of liquidity in the Eurozone in various ways – near zero interest rates, LTRO, TLTRO, etc. Buying sovereign bonds is just another form, albeit on a greater scale. However, as with previous injections, there is a strong chance that this money could get tied up in the banking sector.

Bank loans Debt securities
2002 €5551011 €465854
2003 €5738007 €514908
2004 €5977872 €535208
2005 €6379614 €549080
2006 €7040109 €557293
2007 €7857146 €545236
2008 €8449324 €573546
2009 €8309118 €737317
2010 €8487276 €808361
2011 €8642850 €793326
2012 €8607199 €952468
2013 €8461729 €1007946

Eurozone Non-financial Corporations funding sources (€ '000s)

Non-financial corporations in the Eurozone remain incredibly reliant of lending from banks as opposed to the broader capital markets. This means that any new liquidity injection from QE could end up getting stuck in the banking system as with previous injections. Firms in the US are much less reliant on bank funding meaning QE had more avenues to reach the real economy.Source: ECB, Open Europe.

Bank lending remains the key channel through which QE would filter to the real economy – non-financial corporations get 85% of their funding from banks in the Eurozone, the figure in the US is less than half this. The lack of lending from the broader capital markets means money will not filter through to the real economy anywhere as effectively as in other jurisdictions.

Financial assets as share of household net worth - Eurozone vs US vs UK

49%
82%
62%
In the Eurozone, compared to the US and UK, financial assets are a much smaller share of household wealth. This means that the benefits of boosting asset prices via QE are smaller and that such movements are less likely to benefit the real economy. Source: ECB, Federal Reserve, ONS and Open Europe.

Furthermore, exposure to financial assets accounts for only 49% of net household wealth in the Eurozone, compared to 82% and 62% in the US and UK respectively. This means that boosting asset prices will not feed through to consumers to the same extent.

Different stage of the economic cycle

When QE was initiated in the US and UK, their ten-year borrowing costs were above 4% and 3.5% respectively. Currently, the Eurozone’s is around 1.5%. Since the ECB’s promise to do ‘whatever it takes to save the euro’ in 2012,  borrowing costs around the Eurozone have plummeted – Italian borrowing costs fell by almost 4%, Spanish by almost 5% and Portuguese by over 7%. Yet, this reduction has not been coupled with an improvement in economic performance or inflation. There is little reason to think QE will be any different.

The structure of the purchases

Any sovereign purchases will likely have to be split according to the ECB capital shares. This means that almost half of the capital injection will flow to Germany and France, 26% and 20% respectively. Under a hypothetical €1 trillion purchase programme, only 9.6% of Italy’s, 15% of Spain’s and 13% of the Eurozone’s sovereign debt market would be purchased. This compares to 21.5% in the US and 27.5% in the UK. It is also highly unlikely that a bout of QE would stimulate demand in Germany – and thereby encourage the Eurozone rebalancing many hope for. Germany already sits on plenty of money; it just chooses not to spend it. Its economy is also operating at near capacity.

At the same time, QE would come with a series of political and legal consequences, meaning that the operation would not be ‘cost free’ as some claim. Alternatively, as recent reports suggest, this could lead to the programme being watered down, further limiting its economic effectiveness:

Undermine German support for the euro

If the ECB launches QE, and particularly if the Bundesbank votes against, Germany will be isolated with both political and public opinion hardening. People elsewhere in Europe may not care about this initially, but a German hardening of opinion may significantly restrict Angela Merkel’s political room for manoeuvre in future, for example in case additional bailouts or changes to the Eurozone structure – such as ‘reform contracts’ or a ‘Eurozone budget’ – are found to be required.

Free rider effect

It is highly questionable whether politicians free riding on central banks is sustainable in the long-term. We have already seen this both in 2011, with a lack of banking sector reform, and in 2012 with a lack of reform of the Eurozone’s institutions. Using cheap central bank action to paper over deep economic and political cracks has not proved an effective policy for the Eurozone so far.

Guaranteed legal challenge

QE is guaranteed to be subject to numerous legal challenges, primarily in Germany. The German Constitutional Court has already suggested that it believes the ECB’s OMT programme – purchases of short-term sovereign debt with conditions attached – is illegal. On the one hand, QE is actually a more standard form of monetary policy than the OMT, so it may be on a sounder legal footing. However, on the other hand, questions will certainly be asked about the potential liabilities which will be created for the Bundesbank and the German state via ECB activities. The creation of fiscal liabilities without any democratic process could fall foul of red lines laid out in previous GCC ruling, such as the one on the Eurozone bailout funds. It also ultimately amounts to some joint fiscal underwriting since all Eurozone states support the ECB’s balance sheet.

In the end, QE is likely to deliver limited economic benefit with potential political and legal costs. This is not necessarily to say the ECB should do nothing, but that it is largely doing QE for the sake of doing something, due to inaction from Eurozone leaders. It would prove much more effective to face up to the structural flaws in the Eurozone institutions and find a better way to encourage reform in exchange for fiscal transfers.

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