QE Euro-style: There is no alternative to the ECB writing the check

In: Blog

13 Nov 2011

By: Andrea Terzi

German central bankers (current and former) continue to voice their hostility to what the financial community now calls a Euro-style Quantitative Easing (aka big bazooka). This is the possibility that the ECB (directly, or through the EFSF) make an unlimited commitment to purchase euro bonds and remove the spreads.  Axel Weber, Juergen Stark, and Jens Weidmann have already voiced sharp criticism of the ongoing ECB’s sovereign bond purchase program (SMP, Securities Market Programme), saying it threatens the independence of the ECB.

Amid market rumors that the ECB will soon upgrade the SMP, Jens Weidmann (head of Germany’s Bundesbank) revisited the issue in a speech delivered last week in Berlin. This talk (by one of the boldest opponents of an ECB solution to the sovereign debt crisis) reveals how weak is the position of those who prefer to explore other paths: No real alternative is offered.

Weidmann first advocates what he calls a ‘macroprudential supervision column’. This would allegedly strengthen financial stability by giving the ECB the power to calibrate an additional buffer of bank capital and thus dampen credit expansion as needed. He then goes on to dispute the notion that monetary policy can be used to end the sovereign European debt crisis, and voiced the “staunch opposition of the Bundesbank” to any upgrade of the SMP.

What does Weidmann alternatively propose to save the euro? He calls for countries to “return to a sustainable path of public finance and to undertake the necessary structural reforms” coupled with “sufficient incentives for the member states” when austerity entails “painful and initially contentious adjustments”.
This result he says can be obtained in either of two ways:

One is a “fundamental change in the federal structure of the EU” and “a transfer of national responsibilities, particularly for borrowing and incurring debt, to the EU”.  The Unites States of Europe is a sure solution with a little problem: It demands political agreement of 27 sovereign countries. Is Weidmann aware of the cliff the euro is nearing each day?

The other is a “return to the founding principles of the system, but with an enhanced framework that really ensures sufficient incentives for sound public finances.”  Now, it is clear that (lacking political union) an enhanced set of incentives is needed, but Weidmann offers no explanation of how devising now a new form of discipline could turn things around to save the euro from the precipice.

So why does he oppose the big bazooka?

Here is my summary of Weidmann’s arguments in four bullets (with my comments):

1. The SMP is a form of printing money.

A key clarification here is in order. Anyone who knows accounting and monetary operations knows that “newly printed money” can be injected into the private sector in two ways:

a) deficit spending (through fiscal operations)—which adds so much to net private financial savings; and

b) crediting bank reserves (through monetary operations)—which affects the composition of banks’ assets.

The SMP is a form of the latter.

2. On the economic front, the money printing press solution undermines the incentives for sound public finances, creates appetite for ever more of that sweet poison, and expands the money supply thus raising inflation.

The list of so many evil consequences appears grotesque if only one considers that any other central bank in the world does this routinely when it functions as the market maker of domestic government securities in its open market operations. Also, it is hard to see any evidence that twelve years of euro without such SMP mechanism have produced the type of solid public finances that Weidmann dreams of. Finally, because this is the kind of printing money that affects banks’ assets (and not private equity), no consequence on money supply or inflation is to be expected, and one suspects that Weidmann’s views depend on a lack of clarity in defining what he means by “printing money”.

3. On the political front, the money printing press solution implies a collectivization of sovereign risks among the tax payers in the monetary union. For Germany this means providing rescue funds including “the use of German currency” [sic!] in funding financial assistance to other EMU members.

Again, because the SMP affects neither private, nor national governments balance sheets, the point is moot. And, by the way, will someone please remind Weidmann that Germany no longer has its own currency?

4. Not only printing money is banned by the EU Treaty, but this prohibition is “one of the most important achievements in central banking… a key lesson from the experience of the hyperinflation after World War I”.

The ECB decision to establish the SMP in May 2010 is firmly rooted in the Treaty and the ECB Statute. And of all existing accounts of German hyperinflation, this is the first, to my knowledge, that explains how the Reichsbank ended the Mark in the 1920s through the buying and selling of marketable instruments. (Because this is what the SMP is.)

Weidmann rightly acknowledges that in the euro area “the ultimate decision-making power has remained on the national level and the conditionality that was intended to rein in national policymakers has been increasingly relaxed”. This speaks for a mounting political problem, inevitable when a currency is without a state (see Goodhart 1998). It speaks not against the SMP. Rather, it says that the remaining question is how to dress the big bazooka up to make it politically suitable. And it says that more challenges, once the solvency issue is resolved, await the euro economy.

4 Responses to QE Euro-style: There is no alternative to the ECB writing the check

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Hugo Heden

November 14th, 2011 at 15:42

Good article. Love the quote with the German currency :-)

This fear of increasing Net Financial Assets (for the currency users) is very peculiar. “Printing money”?

As far as I can tell, the Euro system is akin to a gold standard — where the gold stock is not increasing. Even worse than a regular gold standard, in other words. But hey, at least nobody is “printing money”.

(The “currency issuer” has no fiscal branch — there is only the ECB, which is only “allowed” to conduct monetary policy. No NFA ever added.)

The plan seems to be to have a (presumably) growing economy that leverages ever more over this fixed NFA stock, as the decades go by. The result will be stifled growth, or deflationary pressure, or repeated debt crises, or an emerging black market economy based on the dollar — or any combination thereof.

I wonder if this may be the stupidest monetary system in human history.

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Hugo Heden

November 14th, 2011 at 15:48

Oh, another thing — can you help us understand how the banking system in the Eurozone works?

Here: http://pragcap.com/discussion-forum?mingleforumaction=viewtopic&t=206.0

The question is roughly this:

The ECB interest rate is 1.25%. What is that rate for? Is it the inter bank lending rate (“Fed funds rate”)?

Some italian banks currently offer rates over 4% for deposits. Why? Would it not be cheaper for them to borrow in the inter bank lending market?

Or how does it work???

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aterzi

November 21st, 2011 at 17:49

Banks borrow from the ECB @ 1.25% weekly if they have “eligible collateral”. In normal times, 1.25% is also the interbank rate target. Today, banks have used up all their ‘eligible collateral’. The interbank market has dried up. Bank note issues also dried up. Deposits is now the only funding source left.

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Hugo Heden

November 21st, 2011 at 18:59

Ah, thanks! Will forward info to forum.

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