Quantative easing: better late than never

Two years ago, the worst of the eurozone crisis seemed over. Under great market pressure, Mario Draghi, President of the European Central Bank (ECB), had promised to do “whatever it takes” to prevent the single currency from being torn asunder by capital outflows from Spain, Italy and other troubled economies. By offering to buy government bonds in those economies through the new Outright Monetary Transactions programme, Draghi ended the speculative attack on the system without spending a single euro.

The ECB had promised, however belatedly, to use overwhelming force against the markets. The alternative, as even the Germans had recognised, was far, far worse. But once calm was restored to the financial markets, the ECB’s appetite for bold action waned sharply. As so often in the economic history of the eurozone, policymakers seemed too easily satisfied with moderate progress, once the existential crisis for the euro itself had been overcome.

Real Gross Domestic Product growth crawled upwards to an average of only 0.2 per cent in 2013 and 2014. Inflation dropped to 0.3 per cent, and medium-term inflation expectations in the bond market, a key objective for Draghi, fell below the ECB’s 2 per cent target.

Unemployment has risen to over 11.5 per cent. Forecasts for both growth and inflation have both been consistently revised downwards, an unmistakable sign of demand deficiency in the eurozone. Similarities to Japan’s slide into a deflationary trap in the mid-1990s were too close for comfort. Yet, until very recently, the ECB has been very reluctant to take aggressive action to counter any of this.

Contrast this with the performance of the United States. Profoundly dissatisfied with the pace at which unemployment was falling in 2012, Ben Bernanke’s Federal Reserve Board launched an open-ended programme of bond purchases (“quantitative easing, ” or QE3), promising that this would continue until there had been a “substantial improvement” in labour market conditions. Unemployment fell from 8.1 per cent at the time of the announcement to 5.9 per cent now, which is around half of the rate in the eurozone. GDP growth is running at over 3 per cent, and inflation expectations are consistent with the Fed’s target.

No one can be sure whether QE3 was solely responsible for the major improvement in the US labour market in the past couple of years. Some economists point to the role of budgetary tightening, or austerity, in the eurozone, but the fiscal stance in the US has actually tightened twice as much as it has in the eurozone since 2012.

Others point to the clean-up of the banking sector, which proceeded much more rapidly in the US, allowing bank lending to rebound more rapidly. There is some truth in this but, as in Japan in the 1990s, it is hard to unravel the effects of a dysfunctional banking system from those of an over-tight monetary stance. Clearly, both needed to be tackled with some urgency.

There is no doubt that Draghi himself has now become fully aware of the deflationary impetus in the economy. Although he denies that “Japanification” is a realistic threat (for reasons that can be seriously disputed, incidentally), he has now said for the first time that the ECB is constrained by the zero lower-bound on interest rates, implying that unconventional monetary easing will be needed to address the problem. In a remarkable speech in August (remarkable, anyway, for an ECB president), he called for a combination of fiscal easing, structural reform and unconventional monetary easing—the equivalent of Japan’s Prime Minister Shinzo Abe’s “three arrows.”

Unfortunately, eurozone governments have been slow to accept their necessary role in Draghi’s plan, so everything once again seems to rest on the ECB. But the term “quantitative easing” still seems to be taboo in the ECB Governing Council.

Instead, they prefer the term “credit easing,” and have announced a programme of uncertain size to buy private sector assets from the banking system. These will be packages of bank loans (“ABS securities”) and bank debt (“covered bonds”), and there will be ample liquidity on attractive terms for banks that increase their loan books in coming years. Furthermore, the ECB’s Asset Quality Review of bank balance sheets finally promises to start the long process of cleaning up the banking sector.

The failure to follow the Federal Reserve by purchasing government bonds in open-ended quantities has disappointed many critics of the ECB. But its “private sector QE” is intended as a rifle shot aimed directly at the weakest part of the system, which is the zombie banks in the troubled economies. It may work better, given the eurozone’s peculiar difficulties, than any attempt to copy the Federal Reserve’s blunderbuss. As so often before, it is better late than never. Gavyn Davies is a blogger for the Financial Times, former Managing Director of Goldman Sachs and former Chairman of the BBC