Welcomed roundly and long overdue, the European Central Bank’s (ECB) Quantitative Easing (QE) programme announced this week is good news. But it won’t fix the Eurozone overnight.
Although unexpectedly generous, ECB President Mario Draghi’ €60 billion -a month bond-buying plan will take time to make a difference to the Europe’s ailing currency-zone.
Despite the ominously-obtuse title, the central premise of QE is simple – central banks buy bonds and private securities, raising demand for the assets which pushes up their price and reduces their yields.
Market competition exerts pressure on interest rates, forcing them down which makes it cheaper for consumers to borrow. Cheaper borrowing leads to more consumer spending. Firms, who also benefit from cheaper borrowing, can then ramp up their output and invest in expansion.
Growing businesses need more staff, so they begin to recruit and unemployment falls – the net effect being more demand and more money flowing through the economy.
The result? Prices rise as supply struggles to keep pace with rising demand and, hopefully, inflation edges closer to the 2% target.
None of this happens overnight of course, but that’s not the main issue. The problem is what’s happening on the supply (of money) side. Here, the point of QE is to see money flow back into bank deposits, as bondholders take advantage of higher prices to sell-up and make a profit.
More money in banks means more money to lend, and re-lend. BUT, and it’s a big but – recent history tells us real life is (unfortunately) far less predictable as economic models.
When the Bank of England began to engage in QE in 2009, rather than increasing lending, embattled banks used the increase in deposits to bolster their own reserves – increasing the ratio of cash reserves to deposits.
The ratio of the increase in the new money created by QE (narrow money) to the increase in the UK’s total money supply (broad money) fell by a factor of between six and seven. As a result, it took a lot of time before the effects of the programme began to trickle through to the average man or woman on the street.
Such is the state of the majority of Europe’s banks, particularly those in Greece, Portugal and Italy, it looks unlikely anything different will happen this time around. Like the UK’s financial institutions five years ago, banks’ first moves will be shore up their own reserves before they look to lend to consumers.
And QE will do little to address the Eurozone’s underlying structural issues. French and Italian growth (more than one third of Eurozone GDP) remains very weak. Meanwhile European governments have yet to tackle much needed economic reforms.
QE is no panacea for the Eurozone’s problems. It will take a long time before we see its benefits, and even then they may not be as drastic as we might hope, but ultimately it will make a difference. In short, it will work… eventually.