Initial Thoughts on European QE

by Cullen Roche, Founder, Orcam Financial Group

Quantitative Easing has officially come to Europe. Here is the basic outline:

• The ECB is buying €60 billion per month.
• Purchases will include covered bonds, asset backed securities and investment grade national bonds and government bonds.
• The plan will be in force until September of 2016 or until the ECB feels comfortable hitting their 2% inflation target.

You can read more on the specifics at the ECB website.

If you haven’t read my paper on how QE works and what its likely impacts are then you might want to review that.  But here are my general thoughts on Euro QE:

• We know that QE doesn’t cause high inflation.  This makes sense since it’s not adding net financial assets to the monetary system. That is, the Central Bank is merely engaging in an asset swap that changes the composition of private sector financial assets, but doesn’t necessarily expand the quantity of net financial assets. In essence, the Central Bank swaps bonds for cash. No one spends more just because their balance sheet composition was changed so there’s no reason why this simple asset swap should cause high inflation.
• There are side effects, however. The primary impact is on the composition of outstanding privately held financial assets. Since there are now fewer safe interest bearing assets in the private sector QE creates a portfolio rebalancing effect which can increase demand for certain forms of financial assets. This could boost prices which indirectly improves balance sheets and could help with new issuance.  This primarily benefits wealthy asset holders.
• European QE is a positive sign that Europe is becoming increasingly comfortable with more sharing of risks across the entire region. While this form of government bond buying would have been unheard of just a few years ago the entire region has clearly become more comfortable with the idea of sharing the risks across the entire system.  This is a baby step in the right direction towards a more fully unified Europe.
• The bond buying will be proportional to capital subscription in the ECB by each national central bank. This is interesting because it means that over 20% of the government bond buying will be in Spain and Italy where it is arguably most needed.  This will help support government bond sales and further strengthens the ECB backstop at the sovereign level.
• Greece remains a big worry as last night’s elections moved us in the direction of increasing odds of Greek rejection of austerity measures. As I’ve outlined continually over the last few years this remains the greatest risk to the global financial system. If Greece leaves and brings back the Drachma their economy will almost certainly improve given the extreme devaluation we’ll see and this has the potential to cause a domino effect if it appears to be working well.  The EMU really cannot afford to let Greece even consider leaving the Euro at this point. Strangely, Greece has turned into the linchpin in the entire system as their membership remains critical to keeping the whole thing together.

So, will it work? I guess it can’t hurt. But as we’ve seen in Japan and the USA this policy clearly isn’t the bazooka it’s often portrayed as. As I’ve long stated, QE doesn’t have a strong and direct transmission mechanism by which it can impact the economy meaningfully.  And it seems to distract all of us from implementing policy that could have a meaningful impact. Europe still needs real structural changes to solve their problems. They must move towards a US of Europe system with a central Treasury and Euro Bonds or they should move towards some form of dissolution. The current structure simply does not work because there is no rebalancing mechanism within the single currency system (aside from deflation and depression).  QE is a step in the right direction, but I wouldn’t expect it to solve Europe’s problems any time soon.