The president of the European Central Bank, Mario Draghi, surprised everyone last week when he told journalists that ECB does not rule out the use of what economists refer to as quantitative easing (QE).
His actual statement was that the ECB was “unanimous in its commitment” to deploy “unconventional instruments” at its disposal if inflation stays too low for too long. Analysts immediately interpreted the term ‘unconventional instruments’ as quantitative easing.
It is easy to criticise the ECB for taking so long to get to this point when one considers that quantitative easing has been used by the Federal Reserve of the US and the Bank England for a number of years. It has worked to the extent that both these countries have emerged from the recession earlier and the UK can boast that it currently has the highest growth rate among the G7 countries.
The countries with lowest growth rates among the G7, according to the last IMF report, are France and Italy (the second and the third largest economies in the eurozone)
Mario Draghi’s statement came as a surprise because quantitative easing is often described as “unconventional monetary policy”, and Germany has always resisted the notion that a central bank finances government spending. Without German support for quantitative easing, the ECB was really left with only one meaningful tool – the reduction in interest rates.
The risks of QE are that inflation may well rise more than expected and, in spite of having additional reserves, banks will still end up not providing sufficient credit to the economy
Draghi now has the unanimity he wished for and will be tempted to use this tool, as economic growth in the euro-zone is still very fragile and the period of stagnation has protracted itself for a longer period than was estimated.
One needs to remember Draghi’s boldness last summer when he declared that the ECB was prepared to do whatever was necessary to support the euro at a time when financial markets were expecting the eurozone to implode and pundits were betting on when the euro would disintegrate.
That did not happen because of the strong message sent by the ECB, and the latest one on quantitative easing is yet another strong message. The strength of the ECB message is proven by the fact that the interest rate spread between Italy’s long-term bonds and Germany’s has hit an eight-year low. It actually shows how fast the ECB has come to assert its independence from national governments.
So just what is quantitative easing? It is essentially the purchase of longer-term financial assets from both companies and governments aimed at providing more liquidity in the market (as banks end up with additional reserves) and at reducing longer-term interest rates.
The ECB, and in particular Germany, has feared such a policy as it is not far off from the concept of printing money, which may in turn lead to artificial bubbles. It is seen by many as a last resort, when there is little space for interest rates to go down further and banks are unwilling to lend money.
This is different to the traditional monetary policy which is more aimed at short-term interest rates, which however, does not work when these are close to zero as they are at present.
The expected effect of QE is an increase in consumption and investment spending, both private and public, thus stimulating the economy and raising inflation.
It appears to be this latter issue that has been the most worrying element for the ECB. With inflation remaining at well below one per cent, far from the two per cent target of the ECB, and with no indications that it will be rising any time soon, one does appreciate that there is a risk of deflation in the eurozone, even if it may not be around the corner.
The risks of QE are that inflation may well rise more than expected and, in spite of having additional reserves, banks will still end up not providing sufficient credit to the economy. If banks insist on hoarding cash, then output would not have much scope for increasing, leading to inflationary pressures that may become unsustainable.
If, on the other hand, output does increase, the value of the euro is maintained.
How will all this affect Malta? If growth in the eurozone economy does strengthen, this can only be good news for our economy. So we should watch out for what happens eventually so that we would be able to mitigate any negative effects that QE may have on our economy.