Money-making scheme must be made of stronger stuff

13/9/2015

By Wolfgang Münchau

Quantitative easing started in the eurozone six months ago, which makes this a good moment for an early assessment of whether the programme has worked. The European Central Bank did so, and concluded that all is just fine. Most of the disagreements on this subject are of the glass-half-full-or-empty variety. A more interesting question is: what’s in the glass?

Let us recall that the purpose of the programme was to bring the headline rate of inflation back up to the ECB’s target. This is defined as below, but close to 2 per cent. Six months ago the annual headline rate of inflation was -0.1 per cent. The core rate, which excludes energy, food and alcohol, was 0.6 per cent. These numbers have since gone up, by 0.3 and 0.4 percentage points respectively. Was this due to QE? My speculative answer would be: clearly not all of it, but probably most of it — in the order of 0.2-0.3 percentage points. Not a lot, but then again, something.

But this is not the whole story. QE was spectacularly successful in unlocking the flow of bank credit in southern Europe, in Italy in particular. The banks used the money from the government bonds they sold to the ECB to extend loans to businesses and consumers. This ended the credit crunch and also helped revitalise the eurozone money market.

This aspect of the programme was more successful than senior ECB officials expected. It appears that the combination of QE with the other policies may have done the trick. Apart from QE the ECB also made more liquidity available to banks through traditional operations. The deal was: the more the banks lent to the private sector, the more liquidity they received from the ECB.

It would appear at first that this glass-half-full verdict would support the view that QE should continue beyond September 2016, the earliest possible cut-off date. But it does not. The situation is more complicated. First of all, QE is no longer needed to unlock credit. The job is done. If you end QE, the credit channel will not suddenly cramp up again.

What about inflation? If QE raises the inflation rate by two or three decimal points every six months, it may have done its job after three years. In this case it would be best to continue QE until the job is done. But such a straight-line extrapolation would be rather naive.

It appears that most of the macroeconomic effect of QE has already occurred. It led to an immediate spike in inflation expectations. Investors became more optimistic about the economic outlook of the eurozone in general. The consensus in the market was that QE triggered the economic recovery. I call this the fairy dust channel of monetary policy. It sets off a virtuous circle for a few months, during which otherwise rational people start to believe in magic.

This period has ended. The global economy is now turning down again due to a combination of China’s rebalancing, weakness in emerging markets and a fall in equity and commodity prices. The eurozone economy is very sensitive to global demand shifts. In its latest economic forecast the European Commission puts the estimated 2015 current account surplus for the eurozone at 3.5 per cent of gross domestic product. Recall the big economic impact on the eurozone last year when Russia annexed Crimea. This latest shock is going to be bigger. So we are at a point where the fairy dust has settled, and we are looking downhill with clarity.

So what should the ECB do? My view is that it would be best served to focus relentlessly on its inflation target — just like the Federal Reserve in the US — and choose the policy most likely to meet it. With interest rates at the zero lower bound, and the present QE programme not doing the job, that leaves only two alternative choices.

The first is to step up the programme. This is not going to be easy since eurozone governments are all consolidating fiscal policy. They are issuing less debt. There is simply not enough debt out there for the ECB to extend the programme in a large way.

The alternative would be more extreme, and at the same time more realistic: a helicopter money drop — the one monetary policy yet untried. If the ECB gave every citizen in the eurozone a cheque for €5,000, it would have expanded its balance sheet by about €1.5tn. If that does not take care of the inflation problem, send another cheque.

The alternatives are thus not between a glass half-full or half-empty. But between a small glass of water, a large one and a real drink — undiluted.

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