The European Central Bank has announced radical steps to fight the deflationary demons stalking the eurozone. But these only address half the problem and the ECB should consider a more targeted form of quantitative easing
The eurozone has a problem and for once it has nothing to do with sovereign debt – rather it is the creeping, insidious menace of Japanese-style deflation. Average inflation across the 18 member countries dropped to just 0.5% in the year to May, dangerously below the European Central Bank’s 2% target.
In Greece, which owes huge debts, it’s running at minus 2.0%. Meanwhile the eurozone economy expanded by just 0.2% in the first three months of the year and bank lending to the real economy has been contracting for two years. Average unemployment is at 11.7%, but above 25% in both Spain and Greece.
Last week, ECB President Mario Draghi outlined the most radical steps the ECB has taken in its short history to try to kick-start the economy. It lowered the rate at which it lends reserves to private banks to just 0.15% (in the UK it is still 0.5%) and altered the rate that private banks holding reserves at the ECB receive to -0.1%. This means that for the first time banks holding excess reserves will have to pay for them, an idea that has been around for some time but rarely implemented.
The ECB also took a leaf out the Bank of England’s arsenal and began its own ‘Funding for Lending’ scheme, offering $400bn of ultra-cheap four-year long loans to banks on condition that they lend to businesses or households (excluding mortgages).
Most interestingly, the ECB is considering a new form of Quantitative Easing. QE normally involves the large-scale purchase of government bonds, via the creation of new money by a central bank. As the New Economics Foundation described in its report, Strategic Quantitative Easing, the problem with this policy is the new money does not always find its way into the real economy.
The Central Bank buys government bonds typically from institutional investors, such as pension funds, and the investor receives the newly created money instead. Because cash provides no interest to the investor, the hope is that they will use the funds to buy corporate bonds and stimulate the real economy. But there is not much evidence that investors have behaved in this way. Rather, the new money has been spent buying foreign currency or existing assets such as commodities and derivatives.
The ECB hopes to get round this problem by directly buying up real-economy bank loans to households and firms. These will need to be securitised – packaged up to spread the risk of any one loan failing – before they are bought. Previous Monetary Policy Committee member Adam Posen argued for such ‘credit easing’ in the UK in addition to QE to support the SME sector but was blocked by ex-governor Mervyn King. However, the policy appears to be back on the agenda. The Bank’s newly appointed Chief Economist Andy Haldane has backed the proposal and initial thinking has been laid out in a joint paper by the Bank of England and the ECB.
This policy is to be welcomed so long as the central banks involved ensure loans really do support small and medium-sized enterprises. The securities should also be kept reasonably simple and transparent.
But there are numerous potential problems. For one, the SME finance problem is not evenly distributed across the eurozone. The interest rates faced by SMEs in Italy and Spain are double that faced by their counterparts in Germany. It may be difficult for the politically independent ECB to prioritise one Euro-member state over another for these kinds of purchases.
A bigger question is whether the supply of lending is actually still the problem. Europe’s banks are not short of liquidity, indeed they have been rapidly repaying the massive and cheap loans made by the ECB at the height of the sovereign debt crisis in 2011-2012. A recent book by two US academics, House of Debt, presents rigorous statistical evidence that true cause of the ‘Great Recession’ in the States was not a broken banking system.
They suggest the excessive build-up of consumer debt, in particular mortgage debt, meant even after the bank bail-outs households took a long time to start spending again. This, in turn, effects business investment decisions and the demand for bank lending. The same problem may exist in Europe. Indeed, the ECB’s own research suggests the supply of credit, perhaps with the exception of the periphery countries, is less of a problem than the demand for it.
The only way out in such a situation is for government to step in and boost demand via massive fiscal stimulus, as President Obama did to good effect in the first years following the financial crisis. Government spending on infrastructure and building projects in particular have large economic multiplier effects and stimulate supply chains that SMEs can plug in to. In the UK and eurozone, however, governments have actually cut back on spending under the austerity banner.
That said, there may be another cure. If the ECB is seriously considering buying up SME and household debt, could it not also consider buying bonds that would support a massive infrastructure investment? There is a ready-made institution that could act as the body to administer infrastructure loans – the European Investment Bank – whose role is to ‘support projects that make a significant contribution to growth, employment and economics, social cohesion and environmental sustainability in Europe’.
This kind of Strategic Quantitative Easing would not raise public debt levels as no taxpayer money would be involved, but at the same time would rapidly boost employment if targeted at the peripheral economies. When compared with SME loans, it would also leave the ECB with relatively safe and more tradeable assets. In 2011 a similar argument was made, but ignored, by Greek economist Yannis Varoufakis. Maybe it’s time to think again.
Josh Ryan-Collins is senior researcher at the New Economics Foundation. This post first appeared on the NEF Blog
