Wed Jan 28th, 2015 at 02:02:50 AM EST
Along with Time for the ECB Board to be sacked and Another modest proposal, here's another take on what the European Central Bank is about to do.
In an article on Pieria, Frances Coppola looks at the reasons why the Swiss National Bank abandoned its euro floor, a knock-on effect of the ECB's QE announcement. She goes on to imagine that the SNB's floor was still in place, alongside the euro pegs of a number of other European countries outside the Eurozone. The ECB is about to create more than a trillion euros. What happens?
Lets All Play QE
It would create a flow system. I've talked before about leveraging flow systems in relation to bank lending and financial crises. But this is different. It's a deflationary flow system. This is how it works.
In the centre, the ECB pumps out Euros. Some of those Euros may stay in the Eurozone (we hope), increasing economic activity there. But as the Eurozone already has a trade surplus, so is a capital exporter, most will flow out to the Eurozone's trading partners, putting upwards pressure on their currencies. Those partners that have pegs to the Euro will quickly be forced to respond with monetary easing of their own in order to hold their pegs. So as the ECB pumps out Euros, ERM II central banks (and others) mop them up. The ECB exports deflation to its currency partners: those partners export it back to the Eurozone. The only inflation to be seen anywhere will be in central bank balance sheets. This is what the Swiss, who have one of the very few privately-owned central banks, fear.
Countries with euro pegs would not be the only ones concerned.
Lets All Play QE
As Kazakhstan could tell you, you don't have to have an official peg to a currency to find yourself importing the monetary policy of its issuer. All you need is strong trading links.
The result would be "games without borders" in which the Eurozone's close partners adopt monetary easing in response to the ECB's. And so:
Lets All Play QE
So far, the flow system as I have described it would simply inflate central bank balance sheets to no purpose. It wouldn't raise inflation and it would do very little to improve economic activity. This is the fallacy of composition to which I referred. Central banks do not operate alone. The consequences of their actions are felt by others, who defend against them. If the defence is successful, it negates much of the effect. When everyone is weakening their currency with interest rate cuts and QE, no-one can.
But why would this be deflationary, and not inflationary?
Coppola refers to an article by Francesco Giavazzi and Guido Tabellini on VoxEU:
Effective Eurozone QE: Size matters more than risk-sharing | VOX, CEPR's Policy Portal
QE increases aggregate demand through several channels:
- Liquidity and portfolio effects.
There is general agreement that the effects through the first channel will be small. In many countries credit demand remains very weak. Capital rather than liquidity is the main constraint on banks, and interest rates are already very low.
The exchange rate channel is more important, but here too there are some doubts: the Eurozone is not a small open economy (external exports are only 20% of GDP) and the euro has already weakened considerably. This leaves the fiscal implications of QE as one of the most important channels to raise aggregate demand.
As explained by Buiter (2014), when a central bank engages in QE it exchanges government debt for money, which is a non-redeemable liability. This relaxes the intertemporal government budget constraint. The reduction equals the full amount of QE - if the debt is held permanently. The reduction equals the interest payments - if debt is held only temporarily held or it is not rolled over at maturity.
This immediately implies that the fiscal consequences of QE are directly related to the duration of the balance sheet expansion of the central bank. A long-lasting expansion can be achieved by purchasing long-term debt and holding it until maturity, or rolling over the debt purchased.
Even if consumers are Ricardian, the relaxation of the government budget constraint leads to an immediate expansion of aggregate demand - if the expected path of future government spending remains unaltered. This expansion comes because consumers spend more in anticipation of their now larger permanent-disposable-incomes. If, as is plausible, Ricardian equivalence does not hold, the expansion of aggregate demand can only occur if the government exploits the additional fiscal space created by QE to run a larger deficit, through tax cuts or spending increases.
Hence, QE can be a powerful tool to stimulate aggregate demand. Just like `helicopter money', these direct expansionary effects do not rely on portfolio adjustment, liquidity effects, or exchange rate movements (Reichlin et al. 2013).
- The key is that QE needs to be coordinated with fiscal policy and have permanent or long-lasting effects on the size of the central bank balance sheet.
As we might have expected, the ECB's money creation (or at least, most of it) won't find its way into the real economy any more than the ECB's previous liquidity operations did. Exchange rate effects will be minimal too. Only if there were a change in the Eurozone's fiscal stance could QE result in a significant rise in aggregate demand. Dream on.
Lets All Play QE
if all three channels are blocked, as they seem to be, then QE will be ineffective. And ineffective QE combined with fiscal austerity is deflationary. So this is a deflationary flow system - not an acute, Fisher-type deflationary spiral, but a slow burn.
Can anyone point out the flaws in this argument and give us all a nice warm feeling for the rest of 2015?