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QE is not enough

On Thursday, the ECB announced that it would start buying EUR 60bio worth of bonds per month using newly created money. Something like this had been expected by financial markets – but the announcement was at the high end of what we had expected. My job demands that I compartmentalize – questions of whether a policy is good or bad are necessarily pushed back to the weekend in service of figuring out what the eternal question: ‘what’s the trade?’ during the week, but I wanted to take half an hour to ponder what the effects on the real world will be before I have to get back to that grind on monday!

So what will QE do? The ‘First order’ effects on the real (non financial) world are necessarily very small. QE, as expressed by the ECB, creates new ‘high powered’ money – but the name high powered money is misleading because it implies that it’s the money doing the work on the real economy when it isn’t. High powered, or base money, is the kind of money that central banks create for the use of banks – you only have it if you have a bank account with the central banks, which only banks have. QE increases the balances of these accounts. So no one in the ‘real economy’ is going to get any money. Not governments, not people, not firms. It’s not a policy like a tax or subsidy where you can see who gets more money and start your analysis from there. QE is all about the second round effects. Here’s what the president of the ECB thinks those are. according to his press conference on Thursday:

– QE will improve the flow of credit to the real Economy (Our monetary policy measures should support a further improvement in credit flows.)
– QE will increase inflation expectations (Looking ahead, today’s measures will decisively underpin the firm anchoring of medium to long-term inflation expectations. )

The first is in doubt. Banks don’t need reserves on hand to lend, they make loans and seek to cover those loans with reserves later – they lend based on whether they think they are likely to make a profit, not based on how much money they are holding at a given time. There’s therefore no particular reason to think that increasing the balances on banks’ reserve accounts will encourage them to lend – they don’t need reserves, they need profitable lending opportunities. Some argue that QE will increase confidence and therefore lending, but why should increase confidence if there is no obvious causal mechanism for it to work?

The second is even more in doubt – and may not even matter. Many economists believe that if economic actors believe prices will fall, they will put off purchasing decisions, leading to a decline in activity. This is exceptionally hard to observe in real life. However, assuming it’s true, and therefore that increasing inflation expectations is a good way to prevent a falling of activity, why should QE increase inflation expectations? Economic models predict that it should – because economic models assume a fixed multiplier effect between high powered money and credit creation – but this assumption is incorrect.

For me, these two are of quite limited importance. The main second round effect will be from investors who suddenly find themselves deprived of safe assets.Government bonds fulfil a valuable role in the financial system, allowing many savers to preserve their purchasing power without having to really put it at risk. The ECB is going to be buying 100%, or more than 100% in some cases of the amount of government bonds that European countries plan to issue in 2015 – including 100% of Germany’s government bonds. This means that investors will need to find alternative assets. They will be forced into buying riskier or more long term bonds, as well as diversifying into property, equity or whatever else they can find.

This makes me incredibly pessimistic. Given the lack of real investment opportunities in the economy, the supply of good new financial assets will be nowhere near enough to meet the EUR 60bio per month the ECB is planning to buy. This means that investors will be increasingly accepting riskier, more contingent assets as stores for their purchasing power. Given that all this buying is likely to drive up prices of all financial assets, we are once again in a situation where an ever greater mountain of financial claims are building up on an increasingly small base of physical capital. The ECB is now removing the option to at least be able to save with the government for many Europeans. Interest rates on German government bonds are negative on terms of up to 7 years. This inevitably ends in tears. Draghi said at the press conference that monetary policy is not enough to guarantee growth: you need structural reforms as well. He was right. QE is not enough. The Euro crisis may have started out financial, but it’s real now. Trying to force a monetary solution may end up creating more innocent victims.

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