There are good reasons to pump the eurozone with money – but whether it will work, as quantitative easing did in the UK, is far from certain
The rationale for action is clear - growth has more or less stopped
Tuesday 02 September 2014
It looks very much as if Mario Draghi, President of the European Central Bank, will announce tomorrow that the ECB is planning to give some kind of monetary boost to the eurozone economy.
The rationale for action is clear. Firstly, growth has more or less stopped, with the German economy actually shrinking in the second quarter; France stagnant; and Italy back in recession. The ECB is expected to cut its projections for eurozone growth this year from 1 per cent to around 0.6 per cent.
Secondly, the ECB mandate is to maintain inflation below, but close to, 2 per cent in the medium term. The latest figure, for the year to August, is only 0.3 per cent.
And thirdly, there has been an inevitable impact on both business and consumer confidence from the events in Ukraine. Central banks cannot do anything about the root cause of a plunge in confidence but the classic response to any adverse shock is to provide more liquidity to the markets.
The ultra-low inflation, carrying the threat of actual deflation – falling prices – would be justification enough for ECB action, but the case is strengthened by the other two elements. This is textbook central banking theory, as taught to economics students the world over.
Beyond the theory, there is a practical argument in favour of some sort of monetary boost, which is the evident success of the Federal Reserve and the Bank of England (and maybe also the Bank of Japan) in using an active monetary policy to get growth moving. It is always comforting to know that what works in theory works in practice too.
So what will the ECB do? Simply cutting interest rates is not enough, because they are so low already, and in any case the problem is not the price of credit but its availability. The short-term interbank rate is already negative, the German government 10-year rate is below 1 per cent, and perhaps most surprising the average interest rate on 10-year eurozone sovereign debt is now only 1.5 per cent. That is a percentage point below equivalent UK or US debt. But banks have been slashing their lending to companies, partly to meet higher capital requirements, and while to some extent larger enterprises have been able to offset this by making bond issues, that does not help the vital small and medium-sized business sector. Anyway, the total availability of credit has gone on falling.
Up to now the ECB has taken a number of small initiatives – small at least in relation to the problem. For example, banks can go to the ECB and get cheap long-term funds that they can then lend on to companies. A total of €400bn is available later this year, which is big even by the numbers in central banking. But that requires banks to have confidence in their customers’ creditworthiness, so they may not take up the full offer. There is a plan for banks to sell the ECB parcels of loans they have made, but these have to be high-quality (ie no car loans) so the overall impact is likely to be limited.
What the ECB has not done is to follow the US and UK in buying sovereign debt. Every month the Fed has been buying US Treasury debt, though these purchases are now being tapered down. Here the Bank of England holds more than one-third of the national debt, in effect financing the Government. We call this quantitative easing, or QE. The ECB under its statutes is not allowed to do QE. It is not allowed to bail out sovereign governments, the argument being that it was not the job of a central bank to counter government irresponsibility. Germany was particularly insistent on this when it agreed to swap the Deutschmark for the euro.
Two years ago when it looked as though the eurozone might collapse, Dr Draghi famously promised to do “whatever it takes” to save the euro, including supporting the bond markets if they were irrationally destabilising government debt. That just about squeaked by under the mandate on all central banks to maintain orderly markets, but in the event it never had to do anything. The threat was enough. Confidence returned and the markets did the ECB’s job for it.
The issue is different now, but the weapon is the same: sovereign bond purchases, aka QE. The aim is not to save the euro but to pump money into the European economy. Germany in general and the Bundesbank in particular oppose QE, partly for legal reasons and partly because it might take pressure off other governments to reform their affairs. It is also not clear whether QE would work. It worked in the US and UK partly by boosting asset prices but would Europe benefit from a property boom?
Well, we will learn more tomorrow when we get a statement from Dr Draghi. Expect something – the ECB has to do something – but it may be more limited and circumscribed than enthusiasts hope.
Every ‘Boris Island’ we build means shelving other pet projects
Politicians like announcing grand projects, particularly if the bill is likely to accrue long after they have left office. So it is quite in line that the Mayor of London should react aggressively to the idea that a pet project of his should be sidelined by the experts charged with examining its feasibility.
“Boris Island” has a ring to it that extending one of the runways at Heathrow does not quite muster – even if the concept of an airport on the Thames Estuary has been around for at least half a century and really has nothing to do with the current Mayor.
Let’s wait for the report and look calmly at the arguments then, but meanwhile what economists can contribute is to remind everyone of the concept of “opportunity cost”. It is an ugly expression which, slightly simplified, refers to the cost of the projects that you forgo because you have followed a particular course of action. All resources are scarce so if you devote both money and physical resources to one project there will be many others that don’t happen as a result.
These could be other investment projects – more schools in London for example – or they could be current spending, either by government or by individuals. Governments are tempted to fudge such issues. The last one increased public investment without having to borrow the money itself by using more private finance, but the costs of that will be carried by future taxpayers. Investment in renewable energy is being paid for by present and future consumers. And the high-speed rail line means that there are other projects, which bring much greater benefits, that cannot be done as a result of that decision.
So when you hear a politician taking about spending money on some project, ask what they are not going to do as a consequence.
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