In the Eurozone, Quantitative Easing Remains Off the Menu

9 MINS READDec 5, 2014 | 10:15 GMT
A general view of the new headquarters of the European Central Bank in Frankfurt on Dec. 4.
(Thomas Lohnes/Getty Images)
A general view of the new headquarters of the European Central Bank in Frankfurt on Dec. 4.

Quantitative easing is still not an option for the European Central Bank, largely because Germany has forbidden it and because Berlin's stance is not being challenged by Europe's other political heavyweights, which are struggling with different concerns. If quantitative easing were to occur, Stratfor would expect to see a change of rhetoric several months beforehand, either from Germany itself or from other members of the eurozone, highlighting the urgent need to address low inflation.

On Dec. 4, the European Central Bank's Governing Council held its monthly meeting at its Frankfurt headquarters. Europe's financial press gathered at the ensuing news conference, eager to hear an announcement that the bank would soon begin a program of sovereign bond purchases, the monetary policy channel that has grown to encompass the entirety of the phrase "quantitative easing" in Europe. (Elsewhere, sovereign bonds have usually made up just one part of a broad-based quantitative easing program). As always, they left disappointed.

The financial press, encouraged by research notes from leading investment banks, has long been calling for the central bank to undertake sovereign quantitative easing, brandishing the United States' recent quantitative easing-driven recovery as evidence that the measure will solve Europe's problems. Those problems are manifold, but European Central Bank President Mario Draghi faces two truly pressing issues: sluggish projected growth and low and falling inflation within the eurozone.

The Problem of Low Inflation

Quantitative easing in Europe would indeed likely help raise inflation, at least temporarily, by increasing the money supply on the Continent, but it is unlikely that it would stimulate growth the way it has in the U.S. economy. This is because the U.S. lending market is structured in such a way that when the Federal Reserve buys treasuries, the money ends up percolating through to the corporate sector. Europe's bank lending-based economy is less able to replicate this effect.

Nevertheless, falling inflation is still a problem worth addressing. The danger of slipping into deflation is real, but it is largely a psychological menace. In a deflationary world, where prices go down every day, it becomes commonplace for people to delay making any large purchases because the product will be cheaper tomorrow and more so the next day. This expectation of falling prices is very hard to reverse once it has become entrenched in the minds of a population. 

Japan's two decades of struggle provide a cautionary example. It is widely accepted that prevention is preferable to having to actually cure the problem. Deflation is also particularly harmful to countries with high debt levels (such as Greece, Italy and Ireland), because the rising relative value of a currency means the cost of paying back the debt grows every day. With all of this in mind, the economists of the world see a clear imperative for the European Central Bank: Undertake quantitative easing, and do it soon to escape the deflationary trap.

However, Europe is not built in a way that allows it to consider threats in a unified manner. Instead, national politics interfere with EU decision-making. Ever since the euro crisis of 2012, which saw countries in the European periphery struggling with the effects of a sell-off of their sovereign bonds, the German-influenced European party line has been that countries should reduce budget deficits and undertake structural reforms in order to make themselves more competitive.

Germany has drawn a red line around the purchase of sovereign bonds by the European Central Bank, partly in an attempt to maintain incentives for the peripheral countries to undertake reforms and partly because such a purchase would look too much like German money paying for others' transgressions. Moreover, the European Court of Justice is considering a case that could find quantitative easing illegal under European law. A preliminary verdict is expected in January 2015.

Low inflation benefits Germany in some ways. A net-creditor nation such as Germany is actually hurt by high inflation for the same reason it suits debtors: It reduces the value of the payments debtors make. Germany's opposition to sovereign quantitative easing is a major factor, particularly since there has been no opposition from the other major powers in the eurozone.

Silent Assent Across the Continent

But who could be expected to call for sovereign quantitative easing? The main reason a country's leader would push for quantitative easing would be to lower borrowing costs. If the European Central Bank were to buy a country's sovereign bonds, that government would be able to borrow more cheaply. But borrowing costs are already at record lows, and Draghi has been dropping hint after hint all year that he intends to undertake sovereign quantitative easing at some stage. As a result, investors have piled into the bond markets in anticipation of the price increase that would follow the central bank's actions. Since lowered borrowing costs are a benefit of quantitative easing, Draghi has already achieved through talk much of what he could have expected to achieve through actions. As a result, Europe's lending costs are blissfully low at the moment.

Meanwhile, the problematic members of today's Europe — France and Italy — have other concerns. Both are run by insecure leaders who mainly prioritize the survival of their administrations. In France, President Francois Hollande has the lowest approval ratings of any postwar president, and he is trapped between the European Commission's demands for reforms in addition to spending cuts and the traditional socialist elements of his own party that are revolting against such changes. Polls show the opposition party Union for a Popular Movement would take 500 of the national assembly's 577 seats if legislative elections were held immediately. In Italy, a country where leaders tend to lack permanence, Prime Minister Matteo Renzi has made two reforms his priority: The first is a labor reform designed to appease the European Commission, but it is constantly getting watered down to help it get through parliament, possibly eliminating its utility. The second is an electoral reform designed to make his party's hold on power more secure. Combatting the opaque danger that deflation could increase debt positions tops neither Renzi's nor Hollande's to-do list — at least not while debt repayments remain at manageable rates.

One development that would improve the position of both embattled leaders would be gross domestic product growth, which would likely reduce unemployment and increase wages, thus boosting each leader's popularity. The easiest way to stimulate GDP growth would be through increased public investment. The usual course for both governments under such circumstances would be to simply borrow the money and spend it, but unfortunately, high debt levels and the European Commission's increased fiscal vigilance block that particular path. Thus, both have loudly advocated for the next best thing, which is for others to spend money on their behalf. Each was an enthusiastic supporter of European Commission President Jean-Claude Juncker's Investment Fund, although French Economy Minister Emmanuel Macron bemoaned what he considered its insufficient weight. Investment, not quantitative easing, is the word on the lips of Europe's troubled leaders.

But the outlook is not completely bleak for Draghi. Last month, the European Central Bank began purchasing asset-backed securities. Moreover, the second round of Draghi's targeted long-term refinancing operation loans — funding made available to eurozone banks at favorable rates for lending to the private sector — is set to be made available to banks this month with expectations of a better uptake than the September batch. These two measures could positively affect bank lending and help to expand the central bank's balance sheet — currently near 2 trillion euros ($2.5 trillion) — toward Draghi's goal of 3 trillion euros. If he wants to buy other assets, corporate bonds are hypothetically available.

Meanwhile, external circumstances are benefitting Draghi. The end of quantitative easing in the United States has led to an appreciation of the dollar, which has led to a corresponding fall in the euro, improving the competitiveness of eurozone exports and providing a boost to the monetary bloc's economy. At the same time, the dramatic drop in oil prices acts as a tax break, naturally creating the kind of fiscal stimulus France and Italy have been calling for to create growth. (In the immediate term, it can be expected to add to the problem of low inflation). At the moment, it seems the longer Draghi waits, the more favorable the external environment becomes.

Germany's Significance

Thus, in keeping a watch for signs of quantitative easing in Europe, Stratfor will pay little notice to Draghi's hints and insinuations. Instead, the main voices to listen for are German ones. If the German political establishment comes to see low inflation as a major problem for the eurozone, it will consider the idea of undertaking quantitative easing as a solution. This would require Germany to put eurozone concerns ahead of its own to limit the fallout of low inflation's harmful effects on debtor nations. Early signs of Germany seeing low inflation as a problem would be Chancellor Angela Merkel or Finance Minister Wolfgang Schaeuble publicly identifying it as a key danger. Alternatively, a rise in sovereign bond yields in the peripheral countries would concentrate their leaders' minds on the issue and might lead to public statements requiring action from the central bank, in which case a public tussle with Germany would likely ensue. As things stand, the argument is being fought by only one side.

Reports have recently emerged that the European Central Bank's board feels resentful of Draghi's aloof manner. They say he likes to place three mobile phones in front of him at the start of meetings and pay more attention to them than his fellow board members when they are speaking. This paints a picture of Draghi being more interested in the opinion of people who are not in the room, and it has a ring of truth to it. The European Central Bank president's job description is simple: Keep inflation as close to the two percent target as possible. But at the same time, the bank exists by the grace of the nations that make up the eurozone, and thus, it must respect their wishes. If one of Draghi's mobile phones has Merkel at the other end forbidding sovereign quantitative easing while the other two remain silent, it means he cannot pursue the measure, regardless of what he might think is the best course for the eurozone economy.  

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