Quantitative Easing at the ECB – Not Yet in the Playbook

by Claus Vistesen and Edward Hugh

Most sports coaches – irrespective of whether they work in soccer, baseball, rugby or even American football – have playbooks; small books or pads filled with notes, decision rules and strategies for each and every possible situation they can envision. Of course, in some cases the playbooks are mental rather than physical, but every good coach lives and dies by his ability to adapt and react to new and changing situations and in order to do this effectively what he needs above all is a good playbook.

So what has all this waffle about baseball (and Pep Guardiola) got to do with the ECB and how it should respond to the eurozones “evolving” economic and financial crisis? Well, the point surely would be that whatever playbook the ECB works with (and it is sometimes pretty hard to see clearly which one it actually is) there does not seem to be a section on what to do when interest rates finally hit the zero round ( not this month, but next, perhaps, or maybe the one after….) nor do they seem to have a page on that newly fashionable set of tools known collectively and euphemistically as quantitative easing. And this omission may, in the situation we now face, turn out to be a rather large and unfortunate one. The question is, what exactly are we going to do if (or rather when) the Eurozone as a whole falls into a deflation cycle and even more importantly, if it falls into deflation and stays there?

But before we get ahead of ourselves, let’s go straight to the horses mouth (as it were), and take a brief look at what it is exactly the ECB has been doing since the start of the crisis to alleviate the credit crunch and try to reverse the depressing cycle of decline and deterioration which has held Europe’s economies so tightly in its grip. Speaking at the European American Press Club on the 20^th of February ECB President Jean Claude Trichet laid out in some detail the various steps the bank has taken since the crisis broke out in August 2007. Reading through the text of the speech, one major detail immediately strikes the seasoned eye of the applied macro economist, and depending on your point of view the omission is a more or less disturbing one.

At no point in the entire speech does Trichet get to mention (not even once) the effects of the crisis on the real economy. He focuses his entire attention on measures that have been taking in order to ease funding conditions in the interbank market, and in particular on the various classes of credit facility the ECB has been making available to Europe’s banks. Now, you could argue that this absence is hardly surprising given that Trichet was not invited to give a talk about Europe’s real economy, but about the steps the bank was currently taking in the context of the financial crisis and the credit crunch. But this would be precisely the point, since at this moment in time the two are inextricably intertwined, which the credit crunch driving the real economy down, even as the rising unemployment this produces sends risk sentiment in the banking sector to ever lower levels. This being said, the more disturbing part of the whole speech is the sense of complacency it conveys, the impression that Trichet by and large believes the ECB has things under control here with a nominal interest rate running at 2% and that whatever hurdles may lie out there in front of us, no extraordinary measures are needed. If this is the case, I think someone needs to pick up the phone and give the gents in Ivory Tower in Frankfurt a call suggesting they take a peek out of the window; and take a little glance at what is going on around them.

Possibly some may feel that the dichotomy we are making here is a false one since the ECB always held that the measures being taken to normalize conditions in the interbank market were also de-facto intended to cushion the effects of the credit crunch on the real economy. However, using this argument to the current situation is not only misleading, it is also dangerously complacent. Put in more prosaic fashion; this is all soo pre H2 2008.

The facts of the matter are now pretty much unequivocal, and really speak for themselves (or at least they should do).

• The problem in the banking sector and the wholesale money markets was never the main issue. It was merely the initial symptom of a much deeper structural problem in the context of how the whole (global) economy needed to deleverage [1] and how the systematic nature of the money market breakdown would ultimately require government and institutional intervention on a large scale.

• The crisis has now decidedly become an economic and not just a financial one. We won’t belabor our readers here with all those gory economic details with which you are all already so familiar, but we would like to stress that it is now commonplace to suggest that the global economy is taking a hit on the scale that none of us have seen since the first half of the last century, and most specifically, since the years of The Great Depression. So this is no matter to take lightly, even if some economies are hit worse than others. But none of us should be unaware that while the United States is certainly fighting with its own private demons, the locus of the crisis has now slowly but surely moved in Europe’s direction, first via the Southern and Eastern periphery and now into that very bastion of the Eurozone itself – the German economy.
• This is not either the time or the place to examine all the chain-links and mechanism through which crisis transmission operates, but we should all be aware that the force of the blast we are taking at the present time is such, that the very foundations of our common economic edifice – of the Eurozone and even the European Union – are now in jeopardy. When the simple act of transferring deposits from bank accounts in one member state to those in another (in order to speculate on the future of a currency) becomes (and by some multiples) a potentially far more profitable investment than building a factory and creating employment then the seeds of a financial crisis are well and truly sown, and action needs to be taken to prevent the implicit peril coming to fruition. We simply don’t understand how anyone can deny that this problem exists at the present juncture, and something needs to be badly and urgently done to secure the foundations of our edifice before the worst is, by omission, allowed to happen. The economies of the EU and, in particular of the eurozone, need to see the return of profitable investment opportunities as an alternative to idle speculation, and the ECB has a key role to play in this process, by returning price stability, growth possibilities, and above all confidence (that the people in charge actually know what they are doing) to our battered economic system.

In principle, the work that so badly needs to be done should not include extraordinary action and the use of what have become known as “unconventional tools” on the part of the ECB. Indeed in the urgent battle which now confronts us, no door should be closed, in principle. Yet, all of this still remains on the level of “in principle”. The facts on the ground speak for themselves and strongly suggest that the Eurozone now faces not only a strong disinflation process but the advent of outright deflation (as defined by a sustained period of price declines in the core HICP index, see here and again here). Furthermore, the wreckage which is rapidly piling up in Eastern Europe now risks destabilizing the whole system through the deep financial linkages which exist between the banking system in the Eastern countries and those very Western banks which are already beaten to pulp by equity losses and debt defaults in one part of the globe after another.

Indeed, many would claim that once the wheels of the present train crash were set in motion over a year ago it was not particularly difficult to see that the lions share of the problem would end up in Southern and Eastern Europe and in this arrive at the doors of the ECB in the form of both a severe homegrown recession and a near-systemic collapse in the economies of Eastern European. If there was a danger of a repeat of the 1990s Asian style contagion anywhere it was in Emerging Europe, as the Bank for International Settlements and those much maligned ratings agencies never ceased to point out.

However, if we come to look at the responses to date from the ECB, these have in no way been either as drastic or as urgent as those initiated by both the Bank of Japan and the US Federal Reserve (or even the Bank of England and the Riksbank). In fact, far from reacting rapidly and vigorously, ECB council members have repeatedly voiced concerns that interest rates could go too low too quickly, and warned of the dangers of reproducing yet more bubbles. This is soo Japan in the 1990s-ish. Back in December 2008, the councils self-proclaimed hawk, Axel Weber, pointed towards the fact that lowering rates below 2% at that point would imply negative real interest rates, given that inflation expectations in for the medium-to-short term stood at about 2%. Just over a month ago Greek council member George Provopoulos added his voice, by cautioning that there was only limited scope for further rate cuts (towards 1%), citing among other reasons his expectation that the Eurozone would begin to recover in 2010. Specifically, he noted that while there was room for interest rates to go lower if the economy and inflation expectations were to deteriorate further, this would in no case imply a move towards 0%. This view was reiterated some weeks later by Luxembourg’s representative on the Council Yves Mersch when he stated that he was completely opposed to the idea of the ECB adopting a Japanese (or US) type policy of ZIRP (zero interest rates). The reasons normally cited for such continued caution were what one might call the “usual suspects” – namely that while inflation was expected to reach very low levels due to the drop in energy prices it would subsequently rebound in late 2009 (due to the so-called base effects), or that the economic outlook in the Eurozone was fundamentally different that in Japan and the US where the respective central banks had gone much further in the direction of aggresive monetary policy.

Most ECB watchers view the continuing cautious stance over on Kaiserstrasse with a growing sense of bewilderment. In light of the daily slew of incoming bad news it has seemed pretty odd (to say the least) for the ECB to maintain its focus on measures which were clearly lagging the pace of economic development rather than trying to get out in front of the problem and head it off. In fairness, it does now seem that some members at least of the Governing Council may belatedly be moving closer to a recognition of the full scale of the problem. Recently, council member Guy Quaden pointed out that it was perfectly possible for the ECB to lower rates well beyond 2% and that there were no taboos whatsover. Such statements certainly constitute a starting point, but still perpetually create the feeling of “too little too late”, and have done little to persuade financial markets that the ECB is actually in control of the situation.

This problem was further highlighted at the February meeting when rates were kept on hold and where Trichet, in his usuall charming manner, simply noted that ZIRP (and thus QE) had several inappropriate drawbacks, although he did not want to go further (at that point) into what these were. The markets responded well to such obfuscation, and the yield on two year German bunds was pushed to its lowest level since 1997. Symptomatic of the prevailing “zeitgeist” was the statement of Austrian council member Ewald Nowotny to the FT that the ECB would not move into ZIRP as this would imply negative real interest rates, apparently not understanding that this may well be precisely what we need at this point.

As BNP Paribas’s senior economist in London, Ken Wattret, said at the time:

“We’re desperately spinning around to get a proper handle on the issue,” (…) “The worst-case scenario is that the ECB is hoping they don’t need to do things like this because the economy will pick up again. If that’s plan A, then that’s rather disturbing.”

Part of the problem here, of course and as ever, is that there is far from unanimity on the ECB Governing Council at this point. With the stream of council members lining up to give their own personal views to Bloomberg in recent weeks, one might easily say the famous “would the real spokesperson for the ECB now stand up”! The latest “dissenter” in the long line was Athanasios Orphanides, Goverenor of the Bank of Cyprus, who in a speech the 28th of January [2] stated:

The suggestion that monetary policy becomes ineffective when rates are close to zero is a “dangerous” fallacy.

That this sounds vaguely reminiscent of the message which has long been coming across from the other side of the pond should not surprise us since as Bloomberg reporter Ben Sils tells us he is a former Federal Reserve economist (who made a name for himself telling his superiors they were wrong). Sils suggests that events are moving rapidly, and that Orphanides might actually be the one emerging with the upper hand although of course today’s move was the expected 50 basis points. And don’t for a minute believe Orphanides is merely trying to comment on stuff beyond his pay check. There is a real theoretical argument behind this and one which he, himself, elaborates in this paper which discusses how the central bank should attempt to steer expectations towards inflation by “promising” very low interest rates for an extended period of time. (For some considerably more wonkish material on all this, try the Lars E. O. Svensson paper from 2001 or Gauti Eggertsson and Jonathan D. Ostry’s IMF paper on the importance of communicating clearly when you want to make a “credible threat of irresponsibility”).

What are Others Doing Then?

With the ECB being so cautious and unsure about whether or not to engage in what has become known as Quantitative Easing (QE to its friends, for a pretty detailed discussion of QE in Japan and the US try this post here) why don’t we take a look and see just what the rest of them are doing.

Morgan Stanley’s Stephen Jen had a very useful piece on the Federal Reserves’ entry into QE in late November 2008. In the first place it is important to note that QE comes in two stages (although these will now need to be collpased into one here in Europe given the looming deflation threat). The first stage is to attack the credit crunch, and when that attack fails (as it evidently has done, virtually everywhere) the second stage is to try to halt the slide into outright price (and then debt) deflation. In fact, for some time we have been operating a kind of modified version of QE in the Eurozone (without, of course, the presence of the “lower bound”) based on a division of labour between the bank (which has balooned its balance sheet in order to provide short term liquidity to the banking sector) and the national governments who (following the Paris meeting of October 12) have worked on the fiscal side with initiatives to try and move credit by guaranteeing bank loans or buying commercial paper. Now we are about to move into the second stage, which involves first and foremost trying to “steer” inflation expectations. According to Jen there are three key elements in any comprehensive system of QE.

• Communication policy is vital, in order to steer expectations and in particular in convincing market participants that short term interest rates will be held low for a prolonged period of time, even as governments print money on the fiscal side, and even at the risk of “monetising” the growing debt. The point here, naturally, is to try to thrust rather than jolt inflation expectations strongly into positive territory. Judging by all the yelps of pain we are hearing from US market participants about looming inflation Bernanke seems to be having some success here (at least for the moment), and it is a pity we are not able to say something similar about their European equivalents, who, it seems to us, are gradually being steered towards reluctantly accepting either deflation, or at the least very low inflation, as now more or less inevitable.
• The central bank can also increase the size of its balance sheet, and this is a tool that the Fed has been using extensively in an attempt to increase the money supply. For a visual illustration of the process, check out this graph . As for the mechanics, this piece by John Kemp is a good starting point. One significant way in which this can work is, as Kemp notes, by matching increased lending to financial institutions with an increase in deposits these same financial institutions hold with the Fed (a bit wonkish, but still).
• A central bank can also alter the composition of its balance sheet by purchasing securities in an attempt to directly affect the prices of financial assets. This measure is of course intimately connected with the previous point, since without the former there is no great likelihood that the latter will work. In fact, the ECB has already doing something like this for some time now, since it is not at all clear just how many of those assets currently parked over in Frankfurt (and which have been exchanged for liquidity) will ever actually get to leave again. In a general sense, there also seems to have been a rather radical change with respect to the kind of assets the central banks have been willing to accept as collateral for liquidity.

One of the basic cornerstones of QE that has so far been implemented both at the Federal Reserve and at the BOJ has been the aggressive expansion in the purchase of unconventional securities. This could for example be corporate debt as well as, in the US’ case, agency and mortgage-backed securities (together with a veritable myriad of other assets). All of this marks a considerable evolution of the “traditional” QE measures (as practised during an earlier period in Japan) whereby the central bank engages in heavy purchasing of t-bills in order to “manage” the yield curve on the short end and thus allow the government to conduct fiscal expansion at lower cost. Effectively, what we have at the Fed and the BoJ is both an asset and a liability approach where the former takes the form of the central bank accepting the purchase of an ever broader range of assets while the latter takes the form of expanding excess reserves held by banks at positive interest rates.

So, What should and could the ECB do?

Well the answer to this question clearly depends on where you think we are currently at in the Eurozone real economy. In particular, if you are willing to entertain the idea that the bank needs to bring interest rates near to zero and start operating a more aggresive version of QE then you also need to buy the idea that there is a significant and impending risk of deflation in the Eurozone. Basically, M. Trichet’s recent comments to the effect that there is no present danger of deflation in the Eurozone seem to fly in the face of everything we have on the table in terms of economic data, and that we are still a long way from doing the necessary.

However, and in fairness to their point of view, we might start by taking a look at the various reasons which have been offered attempting to argue why it would be inappropriate for the ECB to engage in QE and why some continue to argue that the risk of inflation is still imminent. In order to get to grips with such arguments there is, of course, no better route than by listening to the ECB itself, but since its council members all too often simply offer us their own highly distinct form of newspeak, the following pieces (one by Robert Ophèle Deputy Director at La Banque de France, the other from Sylvester Eijffinger, professor at Tilburg University) are quite useful.

Opèle rightly tries to highlight the distinction between deflation and disinflation, pointing to the fact that what we are currently experiencing is the latter and not the former. Judging by the recent data it is not certain that this view is entirely correct, but he does highlight an important issue in the sense that the key question here is the extent to which one expects rapid disinflation to turn into deflation.

Ophèle uses two arguments in defence of the idea that what we may currently be experiencing is disinflation and not deflation. The first is the fact that the current sharp drop in price levels mainly comes from energy and food prices, and are thus largely giving back the price gains that were so instrumental in driving global monetary policy only a year ago. The second is a much trickier issue, and concerns the degree to which nominal wage rigidity may actually be a virtue in the context of disinflation since it acts as a structural hedge against a collapse into deflation.

This is an extraordinarily powerful and, as it were, convenient argument for those who would defend the current posture of the ECB. In this context it is perhaps worth going back to all those endless disquisitions we were subjected to about the potential for those horrid second round effects as energy prices shot up ever higher and one might thus assume the argument to be a symmetrical one now that energy prices are dropping sharply. However, the presence of nominal wage and general core price ridigity might mean that wages and prices are not sent on a downward spiral by the negative energy proce shock and if one expects the downtrend in energy prices to be merely temporary then, arguably, the monetary stance should not be changed on this account alone.

However this argument may not be entirely valid in the current context. Firstly, it should by now be pretty obvious to everyone that the current correction will have to be deflationary in its consequences those economies in the Eurozone who have accumulated sizeable imbalances over the last eight years. This would then exactly suggest that whatever the trend in energy prices it is the forward looking trend in the core price index we should be looking at. However, Ophèle has an argument ready to hand even in this case:

We should recall that deflation is not possible while households and enterprises continue to expect price rises. This is incontrovertibly the case at the moment. Business surveys, measures derived from market rates, and forecasting experts surveyed by the ECB all point to five-year inflation expectations remaining anchored around 2% for the euro area as a whole.

Shall we run that one by again: deflation is not possible as long as inflation expectations remain positive? This is evidently wrong, since it is basically circular (since prices can’t deflate because households don’t expect them to, and households don’t expect them to because they are running at x% a year), and it does serve to highlight the care one needs to take when interpreting those dreaded (rational?) expectations models. Basically, just because one expects inflation does not mean that you are going to get it and furthermore, expectations may change over time. It is a question here of which is the leading indicator and which the lagging one. There is much more evidence to support the idea that strong inflation expectations may, in some circumstances, be self fulfilling and fuel future price increases, than there is to support the idea that people always and everywhere don’t get deflation because they are expecting inflation. That is, there is a certain asymmetry in the situation. During rapid economic contractions, where excess capacity tends to lead to sharp and unanticipated price reductions, it is far more plausible that expectations follow prices downwards, and this is what we suspect is happening now.

As ever when we have this discussion of expectations the time horizon is the problem. Ophèle is talking about 5 years horizons, and these implicitly embody a high level of uncertainty, especially in an environment like the current one. Quite simply, the key problem for the Eurozone is to keep the edifice together over the next 6 months, not to quibble over some kind of perceived steady state five years from now, and it is this much shorter time perspective which should be in the forefront of ECB thinking right now.

Turning to the case made by Sylvester Eijffinger, an even stronger argument is fielded against the deflation risk in the Eurozone since he not only believes the risk of deflation is slight, he actually thinks the risk of inflation is much higher than that of deflation. Like Ophèle, Eijffinger initially points towards the structural aspects of wage rigidity citing as authority European UnionEconomy and Finance Commissioner Joaquim Almunia who has also advanced the idea that nominal downward wage and price rigidity constitutes a strong line of defense against deflation. This argument would seem to us to be a self defeating one, since if it is valid the future of countries liike Spain, Ireland and Greece within the Eurozone must come under an immediate question mark, since without such downward corrections it is impossible to see how they can ever hope to achieve the competitiveness their economies need in order to grow again. Further, it sees to us to be much more plausible that downward wage rigidity may be much more an issue than downward price rigidity, which means quite simply that as prices fall unemployment simply rises and rises as the recession deepens. In other words the difficulty people have in reducing wages simply means those very same people get sent home rather than working, and thew consequent drop in demand only serves accelerate deflation rather than avoid it. That it, this kind of argument, in a major recession like the one we have now, is totally and thoroughly false.

Basically, the whole problem here boils down to the tricky question of implementing a common monetary policy in the absence of a coordinated fiscal policy not to mention a unified treasury. In this sense and while it is straightforward to see that the Fed should buy US treasuries to conduct QE it is not entirely clear what exactly the ECB either can or should do. For one thing, it is strictly forbidden according to the ECB’s own rules for the bank to enter the primary market to directly purchase securities (read print money) in order to finance fiscal deficits in any member country. Moreover, and if we assume that this small niggle could be dealt with; whose bonds should the ECB buy and how many from each country?

But what if, instead of directly purchasing individual country bonds the bank were to purchase EU bonds explicitly created for the purpose, and what if the produce ofthe same of those bonds were to be deployed by the commission across the Union to fulfil pre agreed objectives. But wouldn’t those bonds be inflationary in their consequence? Of course, we would answer, that is precisely the objective.

Time to Add More Pages to the Playbook?

We realize that this has been somewhat of a whopper of a blog post and if you have made it this far then congratulations, since you obvioulsy have a good deal more stamina than most. Our argument is fairly modest in its aims, since we are absolutely clear at this point that we do not have all the answers. What we have tried to do here is simply draw an intial tentative sketch of what the ECB might do to move forward towards a process of quantitative easing and we have offered some suggestions about how to do this. Clearly, not everyone will be ready to agree with the initial premise that the ECB should consider QE at all. Looking at the incoming data however this move does seem to be increasingly becoming a foregone conclusion even if the ECB itself is not ready to entertain the idea. As such we hope the ideas here expressed may contribute to a wider ongoing debate about what to do about Europe’s present economic and financial crisis, and what kind of measures and tools we have available to deal with it.

Unfortunately, the ECB, and most recently and specifically bank President Jean-Claude Trichet, have been ardently defending a viewpoint based on the non-existence of deflation risk. Today’s, decision to cut interest rates by 50 basis points constitutes nothing more than the expected (not even surprising us with a bold move down to 1%) and this on a day when the BoE seems to have accepted the severity of the UK situation as it bit the bullet and moved itself over to QE. We are not arguing here that the ECB should turn itself into some sort of a rubber stamping clone following blindly along a path laid down by it peers, but rather, that the ECB decision makers should reflect very carefully about the arguments which have lead others along the QE path, since quite frankly, at this point in time the ECBs “originality” is beginning to turn into a liability rather than an asset, and one really has to wonder just how much credbility the institution will have left as and when it really decides to jolt itself back into action. In particular, if it has through either inaction or negligence lead the countries in its charge into a negative deflation cycle, will it still have the credibility left to convince market participants that it has the ability to lead us back out of the mire, into the inflation and into the sun.

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