WEEKLY COMMENT 13-11-2014
By Barry Edwards
Should the ECB Adopt Quantitative Easing?
The European Central Bank (ECB) is concerned that the Eurozone is possibly moving into a period of deflation where prices decline instead of rising gradually with inflation; currently inflation is 0.7% annually and looking as though it could fall further. The standard target for inflation is 2%, which is the economic model most countries accept as the most advantageous course to follow. Japan is the only major country where deflation has happened for some time in recent history and their policy has been to adopt quantitative easing to force their economy into an inflationary cycle to encourage growth of their Gross Domestic Product (GDP).
In case you are not familiar with Quantitative Easing (QE) it is the process of printing money by a Central Bank to purchase government bonds and sometimes any other quoted securities providing it has an investment grade rating, such as the Federal Reserve buying mortgage bonds. The reason for this is to inject cash into the economy to prevent the financial system from freezing up for the lack of money in the banks to finance companies and personal borrowing. However recently, this has meant that central banks have been financing government expenditure directly since the bonds are never issued into the market for investors to purchase.
The purpose of this action is to encourage fund managers and investors to buy assets and securities that have more risk than government bonds to stimulate the everyday economy that ordinary people experience because they cannot buy all the government bonds they wish. It is hoped that investors will chose to invest in businesses of all sizes motivated by the higher growth potential that could be achieved by these companies. Unfortunately, these good intentions are rarely achieved and the result of the massive injection of cash into the economy tends to find its way into the purchase of shares in large quoted companies or secure property investment all around the world. This is the main reason stock markets and property prices are at or near all-time highs.
This has made the central banks in Japan, the USA and the UK large holders of government stock which in reality they will probably hold until they are redeemed. The question now for the ECB is whether it should adopt the same policy of QE to stimulate the Eurozone economy as the other countries have done. Most commentators and bankers believe that it should but the process is not as straightforward as the other countries because they have just one treasury department issuing bonds whereas in the Eurozone there are 18.
Under current rules, the ECB is officially allowed to buy government bonds that have been issued and quoted on the stock markets of Europe; so far this has not happened. The purchase of bonds directly from the treasury departments of each country is specifically disallowed under current rules. The reason for this is it would be considered that the ECB would be financing governments directly and consequently unacceptable. This does not bother other countries including the UK but the EU has resisted so far.
Various statements issued by governments and central bankers within the Eurozone recently are signifying that the resistance to changing this rule of direct QE is melting away suggesting this practice could go ahead if the economy does move into a deflationary spiral. As discussed above, the problem is that QE does not reach the parts of the economy that really need boosting and all the other techniques the ECB is trying, using the banks, are not having much impact either. In time, they may start to improve access to funding for those companies that cannot issue bonds but most commentators are doubtful it will make much difference.
The ECB has expressed its reluctance to begin QE of government bonds for the reasons mentioned which begs the question, what else can be done that will have an effect? The EU exports more products and services than it imports, demonstrating that demand is there. Large companies have the resources to process new orders but SME’s find it hard to fund any substantial new orders they receive. Therefore, finding a mechanism to support that fundamental problem is where the solution really lies. The banks are reluctant to take on the risks associated with SME’s without guarantees or some form of loss protection which means state support in one way or another.
The EU does have some guarantee schemes in place but they are very small and time consuming to process. They are administered by the banks that have to accept around 20% of the risk which is where the problem lies. Expanding the current schemes would not solve the problem without a new set of criteria concentrating on funding new orders. I have suggested ways to improve the support for SME’s see ‘The Economic Growth Plan’ and ‘Venture Beyond’ in the right hand column of this page under categories. These would take time to implement and only have a real impact in a few years’ time. Therefore, another route has to be considered that will work much more quickly.
The only way to get funds quickly into the economy is QE but in my view and that of some commentators is that it should be conditional on funding business growth. It would increase government borrowing but the reward is that it would increase tax revenue and improve economic growth in the short term. Most EU countries have a wide range of structures in place to assist companies with funding including using the banks and expanding the resources available to these organisations, with new criteria to concentrate on SME’s, would have an impact quickly.
The advantage of adopting this technique is that most of the funds are eventually repaid which can pay back the original debt having a short term effect on overall government borrowing. There is no need to set up any new government organisations and there is plenty of expertise in the private sector to make it happen. Therefore, the answer to the question, ‘Should the ECB adopt Quantitative Easing?’ is yes but with conditions. The ECB is going to do something if deflation threatens, we will have to wait and if direct QE is finally allowed to proceed.
That’s all for this week, more observations next week.