The ECB plays at alchemy

With inflation dipping down to only 0.5% in March there is much speculation about whether the European Central Bank (ECB) will finally embrace quantitative easing (QE). The pundits are busy pondering whether it will belatedly follow other central banks in taking unconventional monetary measures to stave off deflation. This is a misleading way to discuss the question.

As Open Europe, a think tank, has pointed out two factors have prompted the excitement about QE. Most importantly a speech by Mario Draghi, the ECB president, talked of using “unconventional instruments” and in the subsequent discussion he confirmed this included QE. There was also a report in the Frankfurter Allgemeine Zeitung, an influential German newspaper, saying that the ECB is modeling the impact of QE of €1 trillion (£820 billion) a year.

Those who are puzzled by the ECB’s apparent hesitancy should remember that eurozone rules officially prohibit the use of QE. Article 123 of the Treaty on the Functioning of the European Union forbids the ECB’s direct purchase of newly issued government debt.

There is some sense to this rule as it prevents the authorities from monetising their own debt. That is the government issuing debt which is then purchased by the central bank. Such a process can be beneficial in the short term, helping to at least postpone a slump, but in the longer term it can have damaging effects. The most widely discussed of these is rampant inflation but in recent times it has mainly helped governments to avoid tackling fundamental weaknesses such as low investment. Monetisation in effect simply stores up bigger problems for the future.

What most of the current discussion misses is that the ECB has long practiced what is known as “back door QE” or “QE in disguise”. This was apparent as far back as 2011 when the ECB encouraged banks to buy government debt. In effect it lent money cheaply to the banks so they could more easily profit from such transactions. This process is known as the longer-term refinancing operation (LTRO).

Back door QE was extended in August 2012 when the ECB announced the introduction of outright monetary transactions (OMT). These involved the purchase of government debt in the secondary markets although the central bank still avoided purchasing new issues.

Of course the exact impact of these schemes differs from those implemented by the Federal Reserve or the Bank of England. As far back as 2012 a study noted that the ECB’s balance sheet had increased massively but, unlike with its peers, much of the liquidity was parked in overnight deposits. The fact that the eurozone is a monetary union rather than a sovereign state also inevitably complicates the operation of QE.

Nevertheless all the main western central banks, including the ECB, are involved in a dangerous game. They may not admit it but they are in effect helping to monetise their own sovereign debt. The government is issuing debt which is then, through direct or indirect means, purchased by the central bank.

In effect the authorities are conducting an experiment in alchemy. They are passing money from one hand to another in the hope that underlying economic weaknesses will magically disappear.

This blog post first appeared today on Fundweb.