So the ECB has, years late and trillions short, decided to act rather than to react. Having passively allowed its balance sheet, shrink By €1 trillion over the last two years it has now decided to inflated its balance sheet by €1 trillion over the next two years. One of the things that central banks are supposed to do is to ensure stability. Looking back from the end of 2016 the gyrations of the ECB balance sheet will hardly inspire. Nonetheless the proposal to engage in quantitative easing, of a sort, is welcome. But its more a constipated squeezing than real quantitative easing. National central banks will be able to purchase this €1 trillion in government debt, in proportion to what is known as the capital key. This is basically the proportion of the ECB attributable to each country. In the Irish context it is 1.7%. Thus the Central bank of Ireland will be able to purchase government bonds to the tune of about €17 billion. Only 25% of new debt issues can abe purchased by the Central Banks and only 33% of total government debt can be held by the Central Banks. It’s not full-blown quantitative easing, as 80% of the activity will be carried on through national central banks. However, 91% of the risk will remain at the national level. There appears to be a concern in Frankfurt of losses. The concern appears to be that were a country to default, or a country to in some way act so as to reduce the value of the sovereign debts that will be purchased then a central bank could find itself sitting on large losses, and might become “bankrupt”. While there can be situations where central banks need fiscal support no such likelihood emerges here. This approach displays a willful ignorance of the nature of central banks, and is both perplexing and worrying coming from a central bank. There is a literature on why losses from a central bank may not actually be that important and in this case would not result in a fiscal transfer were proper ECB level QE be used rather than this hodgepodge. Nonetheless in order to placate the irrational fears of German central bankers who have demonstrated their inability to understand what central banking is about the ECB has put in place a mechanism designed to prevent that which it has said cannot happen, namely that the euro zone breakup. Naming calls…The lack of mutuality demonstrates once again that the ECB is not a central bank for the union and indeed we have no union merely a common currency area. Quantitative easing, in which central banks purchase the bonds of government, is designed to do a number of things. Here is how it is supposed to work. There is reason to doubt that the full effectiveness of these will be seen in the ECB proposal. Increasing the demand for bonds it will drive down the yield, the interest rate, on those bonds. This should help productive investment, by making it cheaper to borrow, and by reducing the hurdle rate projects need to achieve. By increasing the amount of money in circulation it should both devalue the currency, helping exporters, and also result in an uptick in inflation, countering the deflationary tendencies that have begun to take root. The extra liquidity also should allow banks and lending institutions to increase the supply of credit, and the general increase in asset values for financial assets should result in a wealth effect resulting in people feeling richer and therefore spending more, increasing demand. It’s not clear that these are going to happen. In the Eurozone we are already at or near, or indeed in some cases below the zero bond in interest rates. Bond markets are not limbo dancers, no more than they are vigilantes waiting to punish the profligate. Patronising moralizing on debt such as we hear from German commentators is all the more galling for being both wrong in economic and moral terms and for ignoring the inconvenient truth of the 1953 London Debt Conference which lifted the german debt and allowed the new democratic republic we now admire to emerge. If German politicians can stomach the writing off of debt incurred by fascists in a genocidal attempt at world conquest then they can stomach the writing off of debt incurred in an attempt to shortcut living standards to theirs. This may be unpalatable but its the reality of history. What is most depressing is that Ireland has already written off the idea of a debt conference.
- There is surprisingly weak evidence, for the USA at least, that corporates respond to interest rate changes on the downside in relation to productive investment. Given that the USA is more market finance based than Eurozone we might thus expect an even more muted response here. Given the results from the ECB survey on access to finance, SME’s are not in any case especially financially constrained. Demand or the lack thereof is a much more pressing issue. Demand is not, at least in the short term, going to increase from this QE.
- Inflation is likely to remain muted. While a weakening euro will certainly help countries such as Ireland which have significant export markets outside the zone is not going to do anything for intra-Eurozone trade. Export levels are only loosely related to jobs however.
- Within the Eurozone the banking system remains in poor shape. Quantitative easing worked well in the United States because many corporates rely on the capital markets, through bond issuance, and therefore reducing interest rates in these markets is of some benefit. European banks needing to restore their balance sheets by increased profitability are likely to hold this cash, as better positioned US banks did. European banks, responding to an ECB survey, noted that they were using the LTRO (which begat QE) mainly for profitability purposes, with the impact on lending coming from a reduction in margin as opposed to an increase in volume.
- There will certainly be an increase in financial asset values, and in Ireland an unwelcome increase in real asset values in the form of increased boost to the property market. There is in any case relatively weak evidence in Europe for significant financial asset based wealth effects, given its bank based system. Back in Ireland, Central Bank research suggests that there is both an aggregate and a (more complex) micro relationship between house prices and consumption, so a loop (doom or otherwise to be determined later) between rising house prices and rising consumption giving rise to rising house prices may emerge.
There is a benefit to governments. When the central bank takes government bonds onto its balance sheet is in effect almost free financing for the government. They may pay say 2% on these bonds, but this goes to the central bank, and any profits of the central bank, to the government. The flow is therefore circular, near enough. This will be of significant benefit to countries such as Italy, with large amounts of debt needing to be refinanced, and this allowing them to do so close to 0 cost. Savings made on debt service can of course be utilised to pay down outstanding debt, to cut taxes, or to fund government projects. Ideally Europe needs QE plus a proper fiscal stimulus. The danger here is that for a few years the cheaper monies from QE mask poor government finance situations. When the QE unwinds, that is when the Central banks start selling the bonds into the open market, the cost (which may well still of course be low) increases from near zero to the coupon rate. QE gives a breathing space, it is not a replacement for getting the house in order. It is better than the slow suffocation of the last two years. In the Irish context there is of course a set of problems.
- Firstly does the Irish central bank actually want any more Irish government debt sitting on its balance sheet? Having argued in opposition that the promissory notes for Anglo Irish Bank were illegal the government converted these illegal promissory notes into legal fully binding government debt. This debt is now sitting at the central bank… It already has €25 billion so of this stuff. It can’t be compelled to take on any more. We will in effect be relying upon the goodness of heart of Patrick Honohan to help the government in its time of need. It’s not quite the kindness of strangers…
- Second, even if they do we are not able to willy nilly issue debt to be placed in the Central bank and give free financing, as we are constrained by the fiscal compact and need to start reducing our debt/GDP levels not increasing them.
- Third, there are limits to what % of the total Irish government debt can be held by the Central Bank, and we may (depending on how certain assets are counted) be close to this. For a supposedly transparent program the treatment of the IBRC related bonds and other assets the Central Bank holds is anything but clear.
- Finally, the Central Bank is going to be engaged in Lanigans (Bond) Ball. It in principle take €17 billion of government debt onto its balance sheet over the next 20 months, but it will also have to begin to dispose of the €25 billion, the lingering legacy of Anglo Irish bank over the same period. Money will in effect becoming in one door and about another. Even if the IBRC related bonds are ruled as “not counting” for QE calculations they will still have to be sold. When sold they pass out of government hands and pay a private holder 2.5% above 6m EURIBOR, currently about .15%. So, it might make sense, if possible, to at an early date refinance those. The last NTMA bond sold was a 7y bond with a coupon of .8%, so when these pass into private hands the savings are not inconsiderable. Of course, the IMF loans are at 5% so they should be first in the queue. We may save a few hundred million per annum in debt service, but we have an interest bill of over €7b per annum. This is not a gamechanger, welcome though it may be.
The effect of quantitative easing on the Irish financial system will therefore be even more muted than it might be. Winston Churchill in 1922 famously quoted “The modes of thought of men, the whole outlook on affairs, the grouping of parties, all have en countered violent and tremendous changes in the deluge of the world. But as the deluge subsides and the waters fall short, we see the dreary steeples of Fermanagh and Tyrone emerging once again.” Well, the map of central banking in Europe has been changed but we see the dreary ruins of Anglo-Irish bank re-emerging An extended version of my Irish Examiner column of 24 January 2015.