In July 2012, Mario Draghi, the president of the European Central Bank, made a very interesting analogy, in which he compared the euro to the bumblebee. As he said on that occasion: “The euro is like a bumblebee. This is a mystery of nature because it shouldn’t fly but instead it does. So the euro was a bumblebee that flew very well for several years. And now – and I think people ask “how come?” – probably there was something in the atmosphere, in the air, that made the bumblebee fly. Now something must have changed in the air, and we know what after the financial crisis. The bumblebee would have to graduate to a real bee. And that’s what it’s doing.”
In the same speech Draghi also said that the European Central Bank (ECB) “is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” The “whatever it takes” moment that Draghi was talking about around two and a half years back, finally came yesterday.
The ECB has decided to buy bonds worth € 60 billion ($69 billion) every month from March 2015 to September 2016. This bond buying is referred to as “asset purchases” by central banks, “quantitative easing” by most of the Western press and economists and “money printing” by people who want to call a spade a spade.
A central bank has no money of its own. What it has is the right to create money. These days money is created digitally on computers, but printing money just sounds a better way of talking about the entire thing. Quantitative easing involves the central bank printing money to buy bonds. This is done to pump money into the financial system. The hope is that banks will lend this money further. People will borrow and spend this money, which will benefit businesses and in turn, the overall economy. Also, as more money chases the same amount of goods and services, some inflation will be created in the process. As people see inflation going up they will buy goods and services now, in the hope of beating the “coming” rise in price.
This is what the ECB hopes to do with its plan to buy government bonds, bonds issued by European institutions and private bonds every month. The idea is to get banks to lend and consumption going again, in the hope of creating some inflation. For December 2014, the consumer price inflation in the Eurozone(officially called the Euroarea and comprising of countries which use euro as their currency ) fell by 0.2%. The ECB wants to raise consumer price inflation to 2%. When prices are falling people tend to postpone consumption in the hope of getting a better deal.
This impacts the amount of money that businesses make and in order to cut costs they end up firing people. This is already playing out in the Eurozone where employment in countries like Spain and Greece is 25%. The ECB hopes to reverse this.
Before ECB, the Bank of England, the Federal Reserve of the United States and the Bank of Japan, have all tried quantitative easing by printing money and buying bonds. As author Satyajit Das wrote in a December 2014 column for The Independent: “The balance sheets of major central banks have expanded from around $5trillion to $6 trillion before 2007-08 to more than $18 trillion now. In many developed countries, central bank assets now constitute between 20 and 30 per cent of gross domestic product (GDP).”
In another piece Das estimated that the “amount of money injected into the global financial system is sufficient to purchase a large flat-screen TV for everyone on the planet.” Hence, Draghi is only doing what other central bankers before him already have.
By September next year the balance sheet of the ECB will grow by more than a trillion euros due to the bond purchases. The question is will these purchases be effective and help ECB meet its goal of creating 2% inflation?
Analysts at Societe Generale believe that the quantitative easing programme started by the ECB is too small to help create 2% inflation. As they wrote in a research note titled What kind of ECB sovereign QE and what impact? and dated January 16, 2015: “We are fearful that the economic impact will eventually disappoint...ECB QE[quantitative easing] could be five times less efficient than in the US. Hence for inflation to reach close to a 2.0% threshold medium term, the potential amount of asset purchases needed is €2-3 trillion, not a mere €1trillion.”
Draghi also put it clearly in the press conference that he addressed yesterday that only monetary policy was not enough to revive the Eurozone. As he said: “What monetary policy can do is to create the basis for growth, but for growth to pick up you need investment, for investment you need confidence, and for confidence you need structural reforms”. Further, he urged governments to implement economic reforms by saying that “the more they do, the more effective our monetary policy will be.”
Draghi also said that the ECB intends to carry on buying bonds “until end-September 2016”. He clarified that bond buying will “be conducted until we see a sustained adjustment in the path of inflation." This is more or less looks like a clear signal that the ECB intends to buy bonds even after September 2016, if the 2% inflation target is not met. As the Societe Generale analysts put it: “If indeed the inflation outlook continues to disappoint, there is no reason to expect that the ECB balance sheet expansion would stop at €1 trillion”.
This statement of Draghi read along with the “whatever it takes” statement that he made in July 2012 should be a more or less a clear indication that the ECB plans to go in for unlimited money printing until it has managed to create an inflation of 2%. Nevertheless, as I have often pointed out in the past, statements made by central bankers are never so straightforward. As Bloomberg View points out: “An "intention" is not a commitment. And if the program was going to be sustained until it raised the inflation rate to the ECB's target of close to 2 percent, why mention a date at all?” Fair point.
The next question is will the banks lend the money they get by selling bonds to the ECB? The ECB currently charges banks a negative interest of 0.2% for maintaining excess reserves with it. The hope, thus is, that the banks will lend the money that they get from the ECB by selling bonds. But as we have seen in the aftermath of the financial crisis, what normally sounds like a straightforward conclusion using economic theory, often goes for a toss.
When other banks have practiced quantitative easing in the past it has led to massive carry trades. For example, money has been borrowed first in dollars and then in yen and been invested in financial markets all over the world, leading to these markets rallying big time. Does a similar sort of fate await the euro as well? As things stand as of now that is the way it appears to be.
After the dollar and yen carry trades, euro carry trade should take the financial markets by storm and thus help take the era of “easy money” to a new level. The stock market has already given its thumbs up to this round of easy money. As I finish writing this, the BSE Sensex is up around 370 points or 1.3% from its yesterday's close.
(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)
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Updated Date: Jan 23, 2015 13:44:14 IST