18/1/2015
By Wolfgang Münchau
Quantitative easing is, they say, “priced in by the markets”. The European Central Bank will almost certainly announce a decision to buy sovereign bonds on Thursday. Priced in it may be, but such a move would nevertheless constitute a momentous event in modern European economic and monetary history. Something is happening that was not supposed to have ever happened. It is a big step for the ECB, given the ideological corner it started from some 16 years ago. But it is also a marker of how desperate things have become. This is not going to be the pre-emptive version of QE, but the post-traumatic one. Inflation expectations cut loose from the target some time ago. Headline inflation is negative. The eurozone economy is sick.
My understanding is various critical parts of a QE programme were still under discussion by the end of last week though a consensus seems to be emerging on some. The programme will have a nominal figure attached — some say €500bn, but it could be more. It will not be open-ended. Mario Draghi, ECB president, will probably not say he will do “whatever it takes” to get inflation back to target. It will be more a matter of: we will do it; this is what we will spend; and when this is over, we will decide again.
Optimists say the number does not matter. Once you start, the floodgates open, and you will not be able to close them until you have reached your inflation target. The initial size of the programme is thus irrelevant. I fear the floodgate theory is wrong because it misjudges the policy dynamics. If the programme does not succeed, it may be judged to have failed.In that case, it may be abandoned rather than renewed. My plea would therefore be to start with a big programme now. Size matters.
The other important issue under discussion is about what happens if a country defaults. Who will have to pay for the losses? The issue is hideously complex.
What I expect to happen this week is an agreement that will leave the risk of asset purchases in the hands of the governments that have issued the bonds. In other words, the risk will not be shared. That would constitute a huge concession to the opponents of QE, especially Germany. In response, the German government would tacitly accept such a watered-down programme, or at least refrain from a ballistic response. Berlin would almost certainly sue the ECB if that were not the case.
What the German government cares about is not having to pay up if another member state defaults. Keeping the risk on the books of each government would solve the German problem. But in doing so, the ECB might create a potentially bigger one. If Germany wanted to protect itself against, say, an Italian default, would rational investors not try to do the same? Would they thereby offset the gains from a QE programme? Moreover, would the Italian bonds they own be treated in the same way as the bonds the Bank of Italy buys in a QE programme? In the jargon of markets, do they risk becoming “junior” creditors? And finally, would this not lead to more financial fragmentation when the eurozone desperately needs to do the very opposite and create a single financial market?
If you want to understand what risk separation really means, you have to go through the various scenarios under which a country could default — inside or outside the eurozone, unilaterally or agreed, total or partial default, and several combinations of those. Enjoy!
Let us take the example of a hypothetical Italian default inside the eurozone. What would happen? The Bank of Italy would take a loss on the bonds it has purchased. Its capital would presumably become negative. But this is a central bank after all, not an ordinary company. It might just go with negative capital. It might claim some of the ECB’s future profits as part of its own capital. It is, after all, a shareholder in the ECB.It might use some of its gold reserves to prop up its capital. What will happen will therefore depend on the size of the default, the size of the shareholding
in the ECB and the size of any reserves.
It gets even more complicated when a country decides to default and leave the eurozone at the same time.
I will withhold judgment on a QE programme until I see the details. I would opt for a large programme with risk sharing, and accept German litigation. After last week’s ECB-friendly opinion by the European Court of Justice’s advocate general on another case, I would consider such legal action factually irrelevant. And the risk of a German revolt, let alone eurozone exit, as much smaller than the risk of a potentially dysfunctional QE programme.
If the ECB, as I expect, opts to keep the risk on national balance sheets, then the overall impact of the programme will not be known until we have all the details and the legal small print. The effort may still be worthwhile. But a bazooka it is not.
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