Why the opponents of QE have failed to make their case
The European Central Bank is the only major central bank in the advanced world that has not implemented quantitative easing – yet. A lot of arguments have been argued in defence of not following the Federal Resere, the Bank of England and Bank of Japan along the path of QE. But their validity is fast diminishing. Here is why QE’s detractors are wrong – possibly dangerously so.
The first argument advanced against QE is that eurozone monetary policy operates mainly through the banking system. The ECB injects liquidity by directly refinancing banks, against collateral. Since the outbreak of the crisis six years ago the maturity of these operations has been gradually extended and the amounts have become unlimited . However, demand for central bank liquidity has fallen recently, in line with the slowdown of the economy and banks’ concern about their capital requirements. As a result, the ECB’s balance sheet has shrunk . QE would allow the ECB to circumvent the bottleneck in the banking system and directly influence interest rates, regardless of maturity.
The second reason given that QE is not needed is that inflation expectations are well anchored and the current reduction in inflation is temporary and largely due to relative price changes. This argument is not any more valid, as inflation expectations have recently fallen below the 2 per cent mark over the short term and medium term horizon. The recent data also show that the objective of price stability is not being achieved even for core inflation.
Reason number three: QE would inflate the ECB’s balance sheet and create the basis for future inflation. Really? Economic literature has clearly shown that there is no direct relationship between the size of the central bank balance sheet and inflation. What matters is eventually the quantity of private money in circulation, which has been quite subdued over the recent years. The fears of inflation have proved wrong and the main concern today is rather on the opposite side.
Reason number four is that QE may distort asset prices and generate bubbles that may burst – with negative effects on the real economy. It is interesting that this argument is pushed by those who also oppose giving the ECB a dual mandate, adding financial stability to the primary objective of price stability. While it is very difficult to identify bubbles, monetary policy cannot achieve two separate goals with only one instrument. It thus has to focus on price stability and do whatever it takes to achieve it. Avoiding bubbles is a task which should be primarily achieved through prudential regulation. The ECB has now been given extensive powers in this field.
The fifth reason is that by purchasing government bonds, QE would violate the statutory prohibition of monetary financing. However, there is an ample legal and economic literature explaining that asset purchases in the secondary markets are a textbook instrument of monetary policy. All other central banks in the world have used and still use such an instrument. It’s not clear why the ECB should be the only exception.
The sixth reason offered up is that the implementation of QE in the eurozone would require purchasing a basket of national government bonds, which could distort relative prices. This argument misses the key point that the main goal of an asset purchase program is to modify the portfolio composition of financial institutions, increasing their liquidity and thus inducing them to invest in new assets or extend new loans. The assessment of the relative risk-return characteristic of these assets remains in the hands of market participants.
Argument number: QE would lower even further the very low interest rates, thus redistributing income away from net savers, which are mainly in Northern Europe. This is wrong factually and analytically. While nominal interest rates have fallen over the last two years, also in Germany, inflation has fallen even more so that real rates have in fact risen. For instance, in 2012 the yield on German government Bunds was on average lower than inflation (1.5 per cent against 2.1 per cent), it is currently higher (1 per cent against 0.8 per cent). Furthermore, nominal yields are low because inflation is low, and not vice versa. If inflation was higher rates would be higher, which suggests that the longer inflation remains low, the longer rates will have to be very low, as the Japanese experience showed.
The eight argument is that QE is ineffective in raising inflation, especially in the absence of structural reforms. This contradicts the long held view – cherished in particular in Germany – that inflation is ultimately a monetary phenomenon. Without structural reforms monetary policy alone cannot stimulate growth, but there are no reasons why it should not be able to achieve price stability, which is a necessary (not sufficient) condition for growth and job creation.
Finally, it is often stated that low interest rates reduce politicians’ incentive to reform. This may be true, but it is not the task of the central bank to create incentives or disincentives for politicians. The central bank is independent because it aims at one key objective, price stability, and is accountable for it. If it starts giving itself political objectives, it risks losing its independence.
As time passes, and the risk of deflation or low flation increases, the arguments which have been raised against QE appear to be weaker and weaker – and ultimately wrong.