Watch Europe Fumble QE
Tomorrow, the European Central Bank is almost certainly going to start a quantitative easing program, buying up government debt to provide money to banks so they plow it into European economies and thus boost demand and growth. So the theory goes, but the practice of European QE will probably prove it wrong.
ECB President Mario Draghi has no other option after months of political pressure fueled by the panicky fear of deflation. In a way, the ECB painted itself into a corner by targeting headline inflation, not core inflation, which excludes food and energy. When the oil price halved in the last months of 2014, there was no way for the ECB to fulfill its mandate of keeping price growth close to 2 percent a year.
My Bloomberg View colleague Mark Gilbert has pointed out that deflation hasn't undermined consumer confidence in Europe as economists warned it would, and people haven't really been delaying purchases. Yet, according to Jacob Funk Kirkegaard of the Peterson Institute for International Economics, a different danger still exists:
In general, falling prices of specific goods or services do not deter economic activity. The prospect of lower prices of computers does not, for example, keep consumers from purchasing them now. A greater risk to economic growth is that euro area employers, suspecting that deflation will boost real wages, may insist on minimum or even zero nominal wage increases in upcoming negotiations, reducing their purchasing power and dampening growth prospects.
The question is whether the injection of freshly minted euros from the ECB's government-debt purchases will somehow make employers more amenable to raising wages and stimulating demand. For that to happen, the new euros first need to filter down to businesses. There are two ways that can happen: through the capital markets and through banks.
The first path depends on driving down interest rates on sovereign debt so that lenders become more interested in other types of bonds, generated by businesses, and borrowing costs fall. Sovereign debt, however, already yields next to nothing. Germany today sold 4 billion euros ($4.7 billion) of zero percent five-year bonds. Unless the QE drives yields on European sovereign debt deep into negative territory, it's hard to see how the relative attractiveness of corporate bonds could increase by much. In fact, investors' willingness to buy government debt without expecting any profit is indicative of how little they trust corporate lenders.
Besides, in Europe, companies get 80 percent of their financing in the form of bank loans and only 20 percent from the capital markets. London's Telegraph quoted William White, head of the Economic Review Committee at the Organization for Economic Cooperation and development, as saying this would make QE unsuccessful:
QE is not going to help at all. Europe has far greater reliance than the U.S. on small and medium-sized companies and they get their money from banks, not from the bond market. Even after the stress tests the banks are still in 'hunkering down mode.' They are not lending to small firms for a variety of reasons. The interest rate differential is still going up.
A September paper from the Bank of England stated that the U.K.'s massive QE in 2009-2012 didn't result in increased loan activity. "We find no statistical evidence," the paper said, "That those banks who received increased deposits from QE lent more, all else equal."
Even if lending does increase, it's not clear whether that would boost demand enough to drive up prices and spur growth. The ECB's monetary policy is already rather lax, and banks are drowning in liquidity, so lending has been on the rise for some time. According to the latest ECB data, in the last quarter of 2014, net demand for loans to enterprises in the euro area increased to 18 percent from 6 percent the previous quarter, net demand for mortgages rose to 24 percent from 23 percent, and net demand for consumer credit went up to 15 percent from 10 percent. The growth rates were above historical averages, and they had persisted throughout last year. That did not stop inflation from going negative and the economy from stagnating.
"Additional asset purchases are unlikely to stimulate euro area short-term growth because of the difficulty of overcoming poor bank demand for new cheap ECB liquidity and already record low sovereign bond yields," Kirkegaard predicts.
It might be a good time to listen to Mervyn King, the former Bank of England governor who presided over its QE program. "We have had the biggest monetary stimulus that the world must have ever seen, and we still have not solved the problem of weak demand," he said in a public lecture at the London School of Economics on Monday. "I think it's time now to lift one's eyes above the horizon and actually start to look at a wider range of economic factors that are determining the real path of output and demand."
Perhaps it's worth going through with the QE exercise: Until policymakers see its futility, they won't lift their gaze, as King suggests, to consider deep structural reforms, which are much tougher to carry out than government bond purchases.
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