Draghi's dose of QE won’t be enough to save the European patient

The eurozone economy won’t get back on its feet until fiscal policy starts working in conjunction with monetary policy.

It should have happened years ago -- and it should have been more aggressive -- but the European Central Bank has finally announced that it will begin buying hundreds of billions of euros worth of government bonds in an attempt to pull the eurozone out of its economic misery.

Overnight the ECB president Mario Draghi announced an expanded asset purchasing program, encompassing the existing purchase program that covered asset-backed securities and bonds, to the tune of €60 billion per month.

The program is expected to be carried out until the end of September 2016 but Draghi noted that the purchases will be conducted until the ECB sees a sustained improvement in annual inflation that is consistent with the ECB’s annual inflation target of below, but close to, 2 per cent.

Given the ongoing situation within the eurozone, and the lack of a genuine recovery, it seems implausible that the situation will improve sufficiently to cease asset purchases by September 2016. The Federal Reserve, by comparison, conducted three rounds of quantitative easing before the recovery finally found traction and became self-sustaining.

By any measure, the announced program is simply too small to get excited about. Quantitative easing works -- it has supported growth in the US and the UK -- but it offers little bang for your buck. The eurozone is a mess and, in the absence of adequate fiscal policy, will require an unprecedented quantitative easing program to drag them out of it. This isn’t it.

This program will support the financial sector -- banks will be licking their lips -- but don’t expect the additional liquidity to trickle down to the real economy. Equities will boom; bond prices will surge; but the number of jobs created and new projects undertaken will be minimal.

That’s not the ECB’s or Draghi’s fault. He’s doing what he can within the scope of his mandate. The ECB has made its fair share of mistakes in recent years -- raising rates in 2011 for example -- but this isn’t one of them.

Austerity continues to rule the roost in the eurozone -- supported by the troika; Germany, the IMF and the European Commission -- meaning that governments across the eurozone have actively sabotaged the ECB’s efforts to boost growth and generate employment. Unfortunately, austerity measures have done little to ease the debt burden in the likes of Greece, Portugal and Spain.

As part of the program, the ECB will delegate some of the purchases to the national central banks within the eurozone. The risk of these purchases will also be shared among the central banks.

Draghi said that the central banks would buy government bonds in accordance with their share of ECB capital, which is based on each country’s GDP and population. On that basis, around a quarter of purchases will be of German bonds, with French bonds accounting for 20 per cent and Italian bonds for 17.5 per cent.

Draghi also noted that the bank will not purchase more than 33 per cent of any country’s outstanding bonds, nor more than 25 per cent of any individual bond issue. Purchases of Greek government bonds could be limited -- at least initially while there is so much uncertainty surrounding its future in the eurozone.

The asset purchases will be made on the open market -- ensuring that they are reasonably priced -- and the ECB will enjoy equal standing to other bond holders in the case that the debt defaults.

These moves seem to be smart given the irrational apprehension -- largely from the Germans -- to quantitative easing. The Germans have fought the ECB the whole way; distant memories of hyperinflation dominating the reality of the situation: hyperinflation is irrelevant in the presence of a liquidity trap.

Whether this marks a turning point for German policy is an entirely different matter. The sheer size of the eurozone’s predicament suggests that this program may last for a number of years and policy normalisation is unlikely by the end of the decade.

Is the German government willing to support a quantitative easing program that remains in place for anywhere between three and five years?

Over the past year, I have argued that Draghi and the ECB cannot, by itself, drag the eurozone out of this mess. These announcements don’t change that fact.

The recovery in the eurozone will not begin to gain traction until fiscal policy is working in conjunction with monetary policy to support the eurozone economy. With government debt continuing to rise -- despite the harsh austerity measures -- it remains unclear when that will be the case.

Consequently, there is good reason to be sceptical about whether these measures will be enough to boost growth and increase inflation -- at least by September next year.

Related Articles