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by Michael Wohlgemuth
Most Anglo-Saxon economists join politicians in the ClubMed countries in their view that the German obsession with principles (e.g. balanced budgets, the no-bail-out clause or the prohibition of monetizing public debt) is bad for the Eurozone. Kantian “Ordnungspolitik” may be fine for the long run (or may have been fine in the long gone past of the German “Wirtschaftswunder”), they argue, but in times of acute crisis one must do “whatever it takes”.
Let me here concentrate on monetary policy and Draghi’s QE announcement that from March, the ECB will make monthly purchases worth €60 billion of (mostly sovereign) bonds running up to at least September 2016 and thus totaling over €1 trillion. This has long been expected and welcomed by financial markets in London and elsewhere. The President of the German Bundesbank, Jens Weidmann, was pretty isolated in his protest. This situation is very unlikely to change: Germany holds 26% of the ECB’s capital and yet Weidmann has the same voting weight in the council than his colleague from Malta (representing 0.1% of fully paid-up capital).
But such pinprick aside, let me simply ask: Will QE boost the European economy? Will it encourage structural reform? Who will benefit most?
QE is very likely to meet with legal challenges in Germany as happened before with regard to the ECB’s announcement of “outright monetary transactions” (OMT). However, QE seems more justifiable in legal terms as some sort of “monetary policy” since it does not target specific countries for a monetary bail-out and the mutualisation of debt seems limited. At the same time, especially since national central banks will be the main actors in the QE procedure, the German Constitutional Court could more effectively order the German Bundesbank not to take part if it considers QE as being beyond the legal mandate of the ECB.
This is why Mario Draghi is so keen to highlight the monetary reasons for QE. And he has a point. The Eurozone has missed the ECB’s official target of “below, but close to, 2% over the medium term” for some time. Consumer prices have recently dropped by 0.2%. However, the reasons for that should mostly be good news for the Eurozone economy: drastically lower prices for oil and energy, lower food prices, and some Euro-crisis countries enhancing their competiveness via lower wages and prices. At least German central bankers see no signs of a “deflation-spiral” with expectations of ever lower prices hampering investment and consumption.
Many savers, insurers and pension funds rather fear the combination of close-to-zero interest rates and a return to “normal” inflation. Both the German mentality and German law favour low-risk savings; but these already result in real-term losses which the Swabian housewife experiences as a kind of creeping expropriation.
The German Angst of a return to hyperinflation is certainly unwarranted. The main reason is that most of the fresh money is likely to get tied up in the Eurozone’s banking sector instead of fuelling private consumption and investment in the real economy. Over the last years, the ECB has already injected around one €1 trillion worth of liquidity into the Eurozone in various ways (e.g. near zero interest rates and cheap re-financing for banks) – with very little effect on investment and employment to say the least. Instead, the Bundesbank has growing concerns over local asset price bubbles on the housing market, but also on the narrow market for riskier but higher yield bonds.
Anglo-Saxon economists and media refer to QE’s success both in the USA and in the UK. However, the situation is fundamentally different in the Eurozone. The most important channels by which QE could have an effect on the real economy in these countries are unlikely to be as open in the Eurozone.
1. The interest-rate channel
QE should lower borrowing costs not only for governments but also for households and companies. However, the Eurozone is already in a situation where interest-rates are at a record low. When QE was initiated in the US and UK, ten-year borrowing costs were above 4% and 3.5% respectively. They are around 1.5% in the Eurozone today. Most banks can already have as much cheap liquidity from the ECB as they wish. But they use it rather to de-leverage and build up equity – which is reasonable. Or they use it to prolong credit to failing firms – which may lead into a “Japanese situation” with “zombie-banks” that can only survive with cheap ECB credit which they use to re-finance their virtually insolvent customers: both “zombie-firms” and “zombie-states”.
The chairman of the German government-owned development bank (KfW), Ulrich Schröder, recently confirmed that the KfW will contribute €8bn to the €315 billion EU investment programme, remarking however that “there is a small error of reasoning in Juncker’s plan: Europe does not lack liquidity but good projects.”
2. The portfolio-balance channel
Here the idea is that if the ECB buys sovereign bonds, banks use the money to re-balance their portfolios towards purchases of other, riskier, financial assets from the nonbank private sector such as corporate bonds or shares. As corporate re-financing becomes cheaper and asset prices go up, business should be more inclined to invest and asset-owners more inclined to spend. This channel worked quite well in the USA and the UK. However, the European continental capital market is much less developed. In the Eurozone, non-financial corporations get 85% of their funding via bank credit, whereas in the USA broader capital markets allow for more direct lending to the real economy via corporate bonds or other forms of private equity. Hence, the ECB trillion will mostly be stuck in a banking sector in re-construction; it will not find the same direct way to the real economy. Also, since financial assets form a much smaller share of European private households’ wealth compared to the USA, the wealth-effect on private consumption will also be much smaller.
3. The exchange-rate channel:
The most immediate effect that Draghi’s QE announcement has had so far was weakening the Euro against major currencies – although the resurgence of the Euro-crisis after the elections in Greece might have had an even larger effect. With continued economic malaise and political uncertainty within the Eurozone, one can expect that much of the fresh QE money will exploit opportunities abroad, further weakening the Euro. This “external devaluation” may be good news for the German export industry which, however, is already operating at near capacity. Perhaps German firms might import more intermediate goods from other Eurozone countries, but there competitiveness has its limits. Much more than a weak Euro, the Eurozone’s crisis countries need “internal devaluation” – the reduction of unit-labour costs and structural reforms.
But when it comes to the “political channel”, the incentives for Eurozone governments to tackle these reforms, QE becomes counter-productive. For many years now, the ECB has been “buying time” for governments and banks to invest in reforms that should secure sustainable growth and sound balance sheets. However, much of that time has been wasted. With cheap credit and especially with QE, the ECB continues to lower the price of unwillingness to reform. Using cheap central bank money in addition to implicit bail-out promises and mutualized fiscal back-stops has already slowed down the zeal to reform in countries like Italy and France.
Only recently, anticipating Draghi’s QE, Italian 10-year government bonds could be sold at 1.6% – the lowest price an Italian government ever had to pay. And that happened at times of long looming recession, increasing public debt and high levels of unemployment. Will QE encourage the Italian (or other) governments to invest in reforms? Will it encourage Italian (or other) entrepreneurs to invest?
Most likely not. For countries such as Italy or France QE may provide just another excuse to delay and water down reforms such as more flexible labour markets and a less regulated business environment. For the economy in these countries QE is thus bad news. Other countries such as Spain and Portugal have quite successfully engaged in structural reforms (certainly helped by the conditionality of their bail-out programmes). Both countries will hold general elections later this year and there is a chance that less reform-willing parties will win. As far as QE helps these countries to re-finance their debt at low interest rates on the capital markets, their governments can further prove that they have overcome the crisis and no longer need unpopular foreign involvement. This could strengthen their position to stick to the reforms and thus further strengthen their economy as well.
Overall, however, expect the economic effect of QE to be much smaller than often claimed. It could have a positive effect in countries where there already is a positive trend in business and consumer confidence, a sound banking system and good investment opportunities for private investors (e.g. in some export industries or where there is a vibrant start-up scene). It could have a negative effect where these conditions are not met, and where the cheap credit is used by governments to avoid much needed reforms and by banks to avoid much needed re-structuring.
And: expect QE to be much more than just preliminary action in times of crisis. The whole Euro-zone economy and politics will become even more dependent on and addicted to cheap credit. Any return to “normal” monetary policy would shake up markets and governments; and a majority on the ECB board will not take that risk.
A prolonged era of cheap credit at close-to-zero interest rates could either lead to yet another asset-price driven speculative boom-and-bust-cycle or lead the Eurozone towards a “Japanese” situation with prolonged stagnation, record public debt, delayed restructuring of the economy, pension funds in trouble to provide real returns, and “zombie banks” keeping “zombie firms” and “zombie governments” artificially alive.
At this rate, in the long run we will certainly be dead.