BY: JARRETT C. BUNNIN
It’s been called the most controversial weapon in a central banker’s armory, and for a good reason. Quantitative easing, or simply QE, is an unconventional approach taken by central banks with the goal of improving the flow of monetary supply and real currency in any particular geographic area. It involves the purchasing of government or other securities from a market that is currently at risk of deflation, or already in deflation, in order to lower interest rates, which will theoretically increase the circulation of currency. It can support a stagnant economy by reducing government borrowing costs and the future burden of taxation. The unorthodox measure traces its origins as a monetary policy financial tool back to Japan, which after the Asian Financial Crisis of the late 1990’s, was soon plunged into dramatic faltering growth and consumers hesitating to spend. The Bank of Japan’s (BoJ) goal was to, “buy enough securities to create a desired quantity of reserves,” hence quantitative easing. Indeed, this strategy saw initial success in its bond repurchasing program, creating a solid platform through which the economy could recover, despite not significantly altering the domestic inflationary pressures that plagued the country.
After the global financial crisis of 2008 the Bank of Japan started a new round of monetary easing in 2010 as the U.S. dollar became more competitive in international markets once America began its own version of QE. It has been part-in-parcel of Prime Minster Abe’s economic recovery plan, ‘Abenomics’, ever since, which describes a three-pronged approach to improve economic conditions by implementing fiscal, monetary, and structural reforms. However, Japan is still experiencing significant deflation and a lack of consumer investment, 6 years into the three-arrow approach, even with global economic activity picking up over the past year. The country has also struggled to reproduce the same results it had in the early 2000s. The blame cannot all be put on QE for not restoring the Japanese consumer demand; two global recessions in two decades will do that for you. And yet, Japan is hardly alone here, with respect to QE not producing the desired results expected of it by economists from all corners of the globe.
QE as Faustian Bargain Or Legitimate Tool For Monetary Stabilization
After the two recessions of 2008 and 2012, the other three big central banks of the world committed to similar versions of quantitative easing to boost spending, with mixed results. The policy of the Federal Reserve Bank in the U.S. can be divided into three different rounds: QE1, QE2, and QE3, that all targeted improving liquidation in different sectors of the economy. The Bank of England in the U.K. sustained a program intended to acquire high quality private sector assets such as corporate bonds. While the European Central Bank (ECB) took a more straightforward approach in staging a program encompassing the combining of the asset-backed securities purchase program (ABSPP) and the covered bond purchase program (CBPP3) which had been previously launched. The combined monthly purchases would amount to €60 billion. In America, QE has proved to be a success in boosting the economy, whilst in the United Kingdom, it has, in the very least, been able to guarantee stable inflation rates, if not boosting economic recovery. The U.S. ended its program in 2014, while the U.K. did so in 2017 by raising its benchmark interest rate 25 basis points for the first time in a decade. However, the ECB is still in the process of unwinding and arguments abound from both sides, the fiscal hawks and doves, that the timing is either ripe or not ripe enough for doing so.
Indeed, on the European mainland there has been much debate in recent months around whether or not this asset buying strategy is bearing results, and whether or not is should be scrapped in favor of letting the spill-over and permutations of the improving global economic outlook take more control over the European economy. The effects of it are already apparent in the Eurozone, but still, “Patient, persistent, and prudent,” has become the mantra concerning deleveraging QE for the ECB’s dovish president, Mario Draghi. Still, the case for the bank to begin this process of monetary policy normalization is stronger than ever. Since the €2.4tn QE plan began in March 2015, the Eurozone has recovered remarkably from the crisis that hit it in 2012. While still lagging in achieving the desired 2% inflation rate (as measured by the annual change in price index for personal consumption expenditures [PCE]), the economic area is currently experiencing its lowest unemployment period in ten years, consumer confidence and purchase managing indices over the past several months have consistently been at near peak levels since the start of the monetary union, and there is plenty of room for pent-up demand to keep fueling the recovery. What’s more, some have argued that QE is pushing up housing prices in such places like the UK while feeding a bubble on the mainland that could burst one day soon, a prospect that would do tremendous damage to an area that is in the midst of strengthening.
All withstanding, there are equally strong reasons for maintaining the current status quo of asset buying. There are still vast socio-economic disparities that continue to plague the hawkish northern and dovish southern states, stimulating a divide that threatens to hamper developments towards normalization and combat rising populism on the mainland. For example, the German economic machine continues to be at the forefront of the European recovery in recent months, with over 44,000 jobs created in February contributing to a record low unemployment rate of 5.3% in addition to inflation jumping to 1.6% in March. However in Spain, despite inflation edging up slightly in March to 1.3% (one of the better rates among the Southern European states), a 16.1% unemployment rate was second highest in the Eurozone only better than Greece at 20.8%. To truly shrink the unemployment differential between the north and the south, it will require more than just generating stronger growth through monetary policymaking from the central monetary authority. Rather, grassroots policy reforms aimed at addressing the skill gaps in youths between countries like Spain and Germany must be the priority.
Perhaps even more worryingly than the deepening divide between the north and south, real wages have yet to pick up across the Eurozone, despite unemployment rates dropping. This is concerning for a number of reasons, but particularly because the biggest driver of inflation pressure in the longer term is purchasing power for individuals. Without wage pickup, the Eurozone recovery will always be in somewhat of a limbo, as even with a tightening job market buoyed by a strong global economic outlook, people will tend to save their money as opposed to spending it. Angel Talavera of Oxford Economics says that a big reason why inflation is weak is because there is more slack in the economy than previously thought, so there is in fact room for it to grow without triggering a rise in price pressures. Though the chairman of the Federal Reserve in the United States, Jerome Powell, in his first speech in his new role, would argue that the prime culprit is, in a word, Amazon. E-commerce, he argues, is contributing mightily to low inflation in the U.S. as consumers shop around for the best prices on goods, and thus retailers are hesitant to raise their own for fear of losing customers. The EU regulates Amazon and other third-party sellers more harshly than the states, with competition laws being set in place to prevent monopoly by any one single entity over a market. But he may be on to something, and if he is right, and with e-commerce only set to increase as more traditional brick-and-mortar retailers getting into the space, the EU might have a bigger problem at hand – how to raise stubborn inflation in an economic area where all signs are pointing to a growing and repairing economy, save the inflation outlook. Moreover, the knitty-gritty of the hard inflation data does not necessarily support a pullback from QE by the ECB in Q2 or Q3 of this year, in spite of the aforementioned positives that the zone is generating. Shakespeare made famous the soliloquy ‘to be, not to be’ in his elegy Hamlet. The more apt question for the 21st century banking institutions is not whether being is relevant to society or not, but whether or not the policies in place such as QE actually make a difference in people’s day to day lives over a shorter to longer term. Economies are cyclical, and increasingly behavioral, this much we know.
QE has its detractors, but for every detractor there are far more who would argue that it benefits economies. But, those who would argue the former do so from a standpoint where the natural rate of interest is at a stable, albeit lowered, level, and not in negative territory such as the European Union has employed for several years now in a truly amazing experiment to see whether or not this would spur banks towards giving more loans out to businesses rather than hoarding money. While negative interest rates may help spur economic growth by enticing banks, people and investors to buy securities, stocks, or take on loans, the policy has clearly not worked in the Eurozone, having been implemented for several years now and inflation still maintaining stubbornly low levels. The ECB argues that current conditions of financial intermediation suggest that the economic lower bound is safely below the current level of the deposit facility rate, thereby implying that negative rates are not superimposing themselves upon banks profitability. Though they also state that cumulative effects on financial intermediation and stability can be great if rates remain low for a very long time. Low interest rates also undermine another lucrative trick for banks, whereby they borrow money repeatedly for short periods, while lending it out for long ones, creating ‘maturity transformation. At a negative rate banks make their money off of interest, and few depositors now are getting any interest back because banks are not charging borrowers and it is difficult for them to offer the depositors negative rates. While P2P lending may be the future, currently, banks are how people get mortgages, car loans, where they store their cash; they are the life source of economies around the world. This is why so much attention is paid to the nominal rates of interest set by central bankers, because they either help or hinder the smaller players.
QE and negative rates had been planned to last for approximately 4 years, with the former trending down from September 2018 on and the latter remaining in their current lows until at least mid-2019, and the end of Mario Draghi’s term in November that year. But it does not hurt too much to keep it in place for now because of the stubbornness of low inflation as well how current conditions of financial intermediation suggests that the economic lower bound is safely below the current level of deposit facility rate and that the negative rates, when coupled with QE and forward guidance, has been a positive for the Eurozone. Negative rates will remain in place most likely until QE starts unwinding.
Strongman Rhetoric and Fiscal Reform Make Strange Bedfellows
So what are we to make of QE going forward for the Eurozone? There are clear and sound arguments from both monetary doves and hawks for why it should continue, or why it should began unwinding itself now. The safe bet would be to say the dove outmaneuvers the hawk in this instance, given the supported rhetoric by people like Draghi, and his counterparts, Vice President of the ECB Vitor Constancio and Peter Praet, the bank’s chief economist. Given their remarks that, “Inflation, which is our objective, has not yet responded completely to what we wish to see…”, even as the currency bloc’s economy expands rapidly, one could foresee that the bank continues its policy until the 2% PCE target is met. Indeed, despite recent growth putting downward pressure on unemployment, there are still hesitations by consumers that reverberate around the bloc. The zone’s economic sentiment index fell to 19.6 in April from 24 in March while the sub-index tracking expectations dropped into the negative for the first time in nearly two years. This drop in consumer confidence is largely attributed to fears of a global trade war spurred on by the world’s two biggest economies, China and the U.S.
President Trump’s words speak louder than his actions most of time, which perhaps harkens back to his background in business negotiations, and even if it is all done to bring China to the bargaining table as top advisors such as newly appointed Larry Kudlow have said, even the prospect of such a catastrophe spooks investors and the white/blue collar worker alike. Contrary to generating very positive results ,which will grow the economies of the U.S., China, and the World, pandemic like fear is already hurting the global economy in many places such as the Eurozone. Additionally, the U.S. with a drop in the NYSE by several hundred points on the day of the announcement of potential new $100bn in tariffs, as well as in Asia, where countries who trade primarily with China, could be pressured into choosing sides in the war or face tariff/non-tariff barriers to trade themselves. European Central Bank Board Member Benoit Coeure even goes so far as to say that a trade war triggered by US action on Chinese imports will cause a global recession. He argues that the implications of a trade war will have the greatest effect on the U.S., indeed fed officials have already come out and said that this threat clouds the timing of the Fed’s rate increases, and that the Eurozone will only nominally feel its effects. As such, trade war deliberations were not part of the QE and negative interest rates policy stances. Other geopolitical factors may come into play in deciding whether or not to pull back from QE early. Rising populism on the continent as evidenced by recent election results in Italy, Hungary, Austria could potentially hinder growth, through nationalistic domestic policies such as attempting to restrict immigration flows, in defiance of the Schengen agreement. It has been noted that the EU maintains one of the oldest populations on the planet, and a looser immigration policy could improve inflation, productivity (research has shown that immigrants tend to be harder workers in many cases than natives), and wage growth as competition increases for skilled and non-skilled jobs and companies are forced to pay their workers more to attract the top talent.
But, even with all of this, one would not bet against the hawks, especially if, when Draghi’s term ends in 2019, Germany’s Jens Weidmann gets the post of top dog at the central bank. He is a noted hawk on monetary policy, and is considered the favorite for the post even with strong competition from such neutral persons as Erkki Liikanen, the governor of Finland’s central bank and a member of the ECB’s governing council. This author would argue that whichever result happens, continuation or normalization, it is moot in the end if the bloc does not eventually, and sooner rather than later, create a common fiscal policy for all of members using the currency. One of the key lessons of the global financial crisis is that to preserve full financial integration and stability the Eurozone needs fashion a workable fiscal policy that all members can agree to. Such a dramatic transformation would necessarily require treaty changes and constitutional reforms in member states, which in the current state of north-south polarization does not seem feasible anytime soon, but it still must be confronted at some point, particularly in light of another global crisis sparked by a trade war. Enacting such fiscal reforms would allow for the management off aggregate demand and stabilizing policies during large Eurozone recessions.
Monetary rules should govern cyclical stabilization during normal times, such as what occurs in volatile periods of geopolitical uncertainty, or in times of crises or harsh weather conditions. However, sometimes monetary policy alone becomes irrational in the sense that it will be able to solve all problems by itself, as it is held back by zero lower bound on nominal interest rates. Monetary policy must be aggregated with fiscal to sustain demand, or else inflation remains low and deflation even may occur. A Eurozone stabilization mechanism (ESM) as was created in 2010 is but the first step, full fiscal normalization across member states is needed to prevent another recession, as well as fully restore the Eurozone economy. Particularly with all the geopolitical uncertainty abounding. Quantitative easing is but a stopgap tool implemented to put off dealing with the real problem at hand, fiscal reform. No doubt it has helped in some way stabilize the EU economy, as well as hinder it in ways. But the core problem cannot be fixed without a buy-in from member states to want this common policy. Einstein once said that the world as we have created is a process of our thinking; it cannot be changed without changing our thinking. Perhaps nevermore was this so pertinent a diction than in the case of the reformation of the European Union’s financial system. Though one fears that to generate enough appetite to see this level of change to fruition, another critical mass crisis must happen; common ground is most often found in the worst of times, nigh on the best. Regardless, whatever route the bank chooses in the near term, the longer term outlook of the Eurozone will be characterized by larger scale bloc reform.
Jarrett currently works for EY (Ernst & Young LLP) in Business Development and Advisory roles, while concurrently holding a position as a non-resident researcher for the geopolitical consultancy Wikistrat. Additionally, he has experience in the world of think tanks, NGOs and nonprofits, as well as congressional politics. He resides in Tucson, Arizona with his two pugs and likes playing and coaching rugby in his spare time. Jarrett holds degrees from the London School of Economics and Political Science, The University of Arizona (Dual BA), and has spent time at L’institut d’etudes politiques de Paris.
Please note that opinions expressed in this article are solely those of our contributors, not of Political Insights, which takes no institutional positions.