This article was originally published 14 October 2014 on efinancialnews.com.
It was legendary economist John Maynard Keynes who invented the phrase “liquidity trap” to describe how central bank policies – designed to resuscitate an
economy – could fail when interest rates get close to zero. Even though he was writing 70 years ago, he could have been describing the situation in the
Before the crisis, the eurozone's private sector raised about €1.2 trillion of capital on average per year via loans, bonds and equities to finance
investment and consumption. Over the past year, in contrast, the private sector repaid €655 billion worth of capital. That is why using low interest rates
to try to stimulate the 18-member bloc are not working – low interest rates only work if people are borrowing money. Without that, it is like pushing on a
piece of string.
If that is not enough of a headache, it is clear that the 330-million-plus residents of the eurozone are increasingly thinking that inflation is going to
stay rock-bottom. Inflation expectations remain substantially below the European Central Bank's (ECB) target for the next few years, and only begin to
approach it in 2019, when they reach 1.75%. Were those expectations to be realised, it would mean six years of below-target inflation. This has worrying
implications for spending and investment.
ECB President Mario Draghi has reacted to these problems. But will his policies work? That is doubtful. Worse, they potentially kick other big problems
down the road without solving them. Mr. Draghi has a two-pronged attack. First, the ECB is providing unlimited low-cost funds to banks via fixed-rate,
full-allotment auctions. And second, it is encouraging banks to lend funds out into the real economy by offering targeted longer-term refinancing
operations (TLTROs) – essentially cheap money for four years – and via the soon-to-be asset-backed securities (ABS) and covered bond purchase programmes.
For sure, the ECB's policies will pull a lot of assets onto the ECB’s balance sheet, which Mr. Draghi wants. PIMCO estimates the cumulative take-up from
all TLTROs in 2014 and next year will be in the range of €500 billion to €900 billion. Less dramatically, the ECB should be able to buy between €100
billion and €200 billion of ABS and covered bonds – these markets are small and not liquid enough to absorb such a large buyer, and unless the ECB pays
very high prices, PIMCO thinks banks will be reluctant to sell.
These will counteract the natural shrinkage to the ECB’s balance sheet that will occur with the natural unwinding of some of its long-term refinancing
operations from the dark days of 2011 and 2012, alongside other bonds that the ECB bought in the past. Netted out, all this should increase the ECB's
balance sheet from €2 trillion today to about €2.3 trillion to €2.6 trillion next year. That is probably not enough to escape the liquidity trap. And it is
slightly short of the €2.6 trillion to €3 trillion level from early 2012 that Mr. Draghi said he would like the balance sheet to return to.
So, what other options does Mr. Draghi have? The only practical way to raise the balance sheet to that €3 trillion target is quantitative easing (QE), that
is, wading into markets to directly purchase bonds, following in the footsteps of the U.S. Federal Reserve and the Bank of England. It would be nice to
give other policies time to prove their effectiveness, but time is in short supply if the ECB is to stop low inflation expectations from being set in
concrete. If credit and economic growth do not respond positively to the ECB's existing policies in the coming months, a QE programme that sees the ECB
purchase €500 billion of government bonds will be needed.
Germany's hyperinflation in 1923 left generations of its citizens mistrustful of central banks that fund prolific government expenditure. Mr. Draghi is
thus unlikely to find unanimity among the ECB's Governing Council for QE. To be fair, those who argue against QE have a point: Monetary policy alone cannot
solve the eurozone's problems. And the more action the ECB takes, the less the incentive for European governments to make the tough policy decisions at
home to reform their economies and boost growth.
We believe Mr. Draghi should push on regardless. While reforms that boost potential economic growth and make labour markets more flexible are sorely needed
in Italy and France – even Germany's labour market is overly rigid – these reforms would be even more painful for voters if the eurozone was in a deep
slump. Seen from that angle, monetary stimulus can support politicians’ implementing structural reforms, rather than encouraging delay.
QE can sooth the eurozone's problems, but not solve them. To ward off deflation and endure in perpetuity, the eurozone needs policies on interest rates,
QE, taxation and growth to work in unison. Monetary policy buys time, and more accommodation in the form of QE will enable politicians to contribute their
part of the growth bargain. Reforms that reduce red tape, make labour markets more flexible and increase productivity are needed to boost potential growth.
Public expenditure can be made more productive by focusing on investment.
Ultimately, however, politicians will have to centralise some expenditure and revenue in a common budget presided over by an elected eurozone parliament.
No other monetary union has survived without this. A common budget of 5% to 10% of eurozone GDP should suffice to smooth out regional growth imbalances and
relieve the ECB of its role as firefighter.
This transition would be accelerated if agreement could be reached to issue common bonds guaranteed by the bloc instead of by each government. By providing
an asset without credit risk, they would enable an insolvent member state to restructure debt without tearing the common currency apart. The political
appetite for this, however, is close to zero.
Even with all these measures, however, it is doubtful that the eurozone can get itself out of the liquidity trap. And QE also delays the day of reckoning.
The eurozone needs to get its debt to sustainable levels through economic growth. Without that, and without creating tighter fiscal and political
integration among its members, concerns about the level of Europe’s debts will inevitably resurface.