The sad consequences of the fear of QE

By Paul De Grauwe | London School of Economics

Paul De Grauwe, John Paulson Chair in Political Economy at the London School of Economics, gives his thoughts on the ECB meeting this Thursday, where Mario Draghi is expected to announce a programme of quantitative easing.

IT APPEARS that the European Central Bank (ECB) is ready to start a large programme of “quantitative easing” (QE): it will buy government bonds and in so doing will put money base into circulation.

There is still a lot of disagreement on the necessity of QE in the euro zone. I see two reasons why the case for QE is overwhelming. First, QE is merely a correction for what happened during the last two years. During that period, the ECB withdrew about €1 trillion out of the euro-zone economy. Admittedly this was the result of banks repaying loans they had taken during the height of the debt crisis. But surely central banking is more than passively reacting to decisions taken by banks.

Second, the euro-zone economy is not getting off the ground. This contrasts with America, Britain and the non-euro EU countries. More importantly, the ECB fails to achieve the only objective it takes seriously, ie, an inflation target of 2%. Since the end of last year inflation in the euro zone has become negative.

Since Milton Friedman we have all become monetarists. In order to raise inflation it will be necessary to increase the growth rate of the money stock. This requires that the ECB increase the money base. And to achieve the latter there is only one practical instrument, ie, an open-market purchase of government bonds. There is no other way to raise inflation than through an increase in the money base and a bond-buying programme is the time-tested way to achieve this.

But as stressed by many observers, QE alone may not do the job. It is necessary but not sufficient. The fact that it is not sufficient, however, should not lead to the conclusion that it can be dispensed with. Even if little else is done, QE should have a significant effect on the exchange rate of the euro. By increasing the supply of money base the ECB will contribute to a further weakening of the euro vis-à-vis other currencies such as the dollar, the pound and the yuan, thereby increasing exports and boosting inflation.

There is much misunderstanding and fear regarding QE, especially in Germany. There is the fear that if the ECB buys government bonds from countries like Greece, Italy and Portugal, German taxpayers risk having to foot the bill. This, the argument goes, will happen if one or more of these countries defaults on their debt. Such a default will create a loss on the balance sheet of the ECB. The other member countries in the euro zone, especially Germany, will then have to step in to cover the loss. The fear that taxpayers may be forced to cover future losses of the ECB has become the main reason why the ECB has waited so long to begin QE.

What to think of this fear? I think it is unfounded. In fact it is surprisingly easy to implement QE without creating risks for taxpayers of the "strong" countries of the euro zone. The way to do this is as follows: the ECB buys a portfolio of government bonds in proportion to the economic weight of each country in the euro zone, as represented by the equity share of these countries in the ECB. Thus, the ECB buys 27% German bonds, 20% French bonds, 18% Italian bonds, etc. As long as these bonds are kept on the ECB’s balance sheet the governments of these countries pay interest to the ECB. The ECB could then apply a rule of “juste retour”, ie, it reimburses the same amounts to each of these governments. No fiscal transfers between member-states occur.

If one of the governments, say the Italian government, were to default on its bonds, the Italian government would stop paying interest but at the same time (applying the “juste retour”) it would not get any interest refund. Again there would be no fiscal transfers.

What about the need for the ECB to write down the Italian bonds? Would that not lead to a fiscal transfer? The answer again is negative. Such a write-down is purely an accounting operation, without any implication for the taxpayers of other countries.

This is not often well understood. When the central bank writes down the Italian bonds, the value of its assets declines. The counterpart on the liabilities side of the central bank’s balance sheet is a decline in equity. A central bank, however, does not need equity. It can easily live with a negative equity. When the equity of the central bank declines there is no need to call upon taxpayers “to foot the bill”. There is no bill to be paid.

Unfortunately, the ECB (and many other central banks) keep this fiction of the need for equity alive, by asking the participating governments to “recapitalise” the bank. But such a recapitalisation is also a purely accounting convention without implications for taxpayers. It implies that governments place bonds on the ECB’s balance sheet. These bonds then create the same circular movement of interest payments, ie, the governments make interest payments to the ECB and the latter refunds these back to the same governments. No taxpayers are involved.

This confusion between accounting losses and real losses is unfortunate. It has led to long hesitation to act. It also leads to bad ideas and wrong proposals. The compromise the ECB is now likely to move towards, whereby each national central bank buys its own government bonds is such a bad idea. One can argue that from the point of view of risk sharing it is equivalent to our “juste retour” proposal. But in going into that direction the ECB creates a perception that the unity of action in the monetary policy field is lost. This is not good news for the future of the euro zone.

The sad thing about this likely solution is that one can achieve the same objective, ie, preventing fiscal transfers between member-states, without compromising the unity of action of the ECB.