Monday, 12 January 2015

To QE or not to QE

That is the question the ECB will have to address during its forthcoming policy meeting on the 22nd January 2015.

The arguments for QE ( Quantitative  Easing  - a pseudo technical term for creating fiat money out of thin air to compensate for the fall in the velocity of circulation of money) are:

  1. Everybody is using QE and it has given good results in USA and UK and it also seems to be working in Japan.
  2. The Euro area is too close a zero inflation and very far from the ECB target of close but below 2%.
  3. ECB has exhausted its conventional monetary tools especially with interest rates at near zero and negative interest rate on liquidity parked by banks with the Central Bank.
The arguments against QE:

  1. In the context of Euro area where there are 19 national governments and 19 Treasuries QE is difficult to implement effectively as there is no single Euro area bonds to represent all Euro area governments.
  2. In the absence of such Euro bonds, about which there is no political agreement, the ECB would have to buy sovereign bonds to implement QE in ratios which reflect the shareholding spread of member countries meaning that QE for the ECB would not be the clinical tool it needs to be.
  3. As a result of 2. the ECB would have to buy bonds of core Euro countries where there is no need for QE and will not be buying enough sovereign bonds of periphery countries where there is huge need for QE intervention.
My opinion is that QE will prove largely ineffective in a Euro area context.   The ECB rather than QE should be looking to purchase on a large scale basis of bonds issued at very preferential rates and terms by pan-European financial institutions like the European Investment Bank ( EIB) and the European Stability Mechanism (ESM).    These are pan-European institutions which would not involve the ECB in forced buying of German sovereign bonds when this is totally unnecessary.

Furthermore the bonds issued by the EIB and ESM could be applied to effective uses to revamp the European economy.   EIB would invest these funds into the newly (yet to be) set-up under the Juncker Plan European Fund for Strategic Investment (EFSI).   The ESM would invest these funds to recapitalise through low coupon preference shares European Banks that need additional capital in order to honour the more rigorous CRD IV capital requirements regime but at the same can still provide an effective mechanism for channelling credit to where it is mostly needed ( European SME's who depend on a regular flow of bank credit) in accordance with monetary policy decisions taken by the ECB.   This will remove the blockage in the transmission mechanism of monetary policy which is denying SME's the opportunity to benefit from low interest rate credit as intended under the ECB's monetary stance.

So the question should not be whether or not to QE but whether or not to do something bigger and more effective.

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