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Will the ECB do ‘whatever it takes’?

Banks expect that a deal on Sunday will prompt the ECB to pump liquidity into the system and raise the cap of emergency liquidity assistance

By Stelios Papadopoulos

GLOBAL markets rallied recently on expectations that the European Central Bank (ECB) had moved a step closer to making billions of euros in asset purchases – otherwise known as quantitative easing (QE) – to jump start the region’s spluttering economy and avert a deflationary spiral.

Shares rallied on August 25 and the euro fell from $1.3198 from $1.3142 late Friday. QE can send the currency lower. Investor bullishness followed comments by ECB president Mario Draghi at the central bankers’ Jackson Hole summit in Wyoming that the ECB could use “all the available instruments”, widely assumed to include asset purchases, to stabilise prices. He acknowledged that low inflation – a sign of weakness – could be getting worse.

In quantitative easing a central bank creates new money and uses it to buy financial assets such as bonds. That pumps newly created money into the financial system. It can in theory increase the amount banks can lend, push up the price of stocks and other assets, drive down interest rates, and increase inflation.

However there are legal, political and practical hurdles to doing it in a multi-country currency union and so far the ECB has held off.

Draghi also urged European governments to move past their focus on austerity and do more to boost growth with tax cuts-offset by spending cuts to remain within the strict EU limits on government deficits. He called on them to push ahead with long term structural reforms such as more flexible rules on hiring and firing (i.e structural reforms). He also endorsed a 300 billion euro programme for public and private investment proposed by the incoming president of the European Commission.

Mario Draghi famously said in the summer of 2012 that the ECB will do “whatever it takes” to preserve the euro. The impact of that statement was historic as it led to decreasing government bond yields and a period of relative stability. It was essentially a warning to speculators – who were short selling Italian and Spanish government bonds – that if they continued betting against the euro, the ECB would step in with a bond buying programme which came to be known as OMT.

OMT was never used but the mere possibility of it coming into existence was enough to convince them to retreat. It was never though popular in Germany which is why Draghi enticed Europe’s most powerful government with the so called fiscal pact, a stronger version of existing limits on government deficits. Draghi’s 2012 statement therefore can be understood as a bluff precisely because OMT was never used. This basically means that speculators were not sure whether the ECB would actually start purchasing government bonds, which is why they were reluctant to challenge him by betting against the euro.

Commentators in the business press described Draghi’s recent Jackson Hole statements as unexpected, since the ECB was never so explicit about the dangers of low inflation. Accordingly it is this “unexpectedness” they say that makes QE a very real possibility. Yet his unexpected statements can be read differently when his track record on OMT is taken into account.

Because just as his 2012 bomb worked precisely because – like any other bluff – it was unexpected, the more recent ones may do the trick without pulling the trigger, as the euro’s recent fall and consequent higher inflation serve to demonstrate. Draghi however has only bought time since low levels of inflation are a deep structural problem and sooner or later this will require raising aggregate demand.

Moreover his speech does not refer explicitly to any QE. He referred to the dangers of low inflation but as he pointed out, low inflation can be battled with tax cuts, investment and the existing flexibility of the EU’s deficit-spending rules.

This suggests that some stimulus that does not violate the EU’s rules can raise inflation without having to resort to QE. However, he also points out that any changes in fiscal policy have to be “coordinated” at the European level. In other words any changes will require German support. Furthermore the only countries where the rules can be relaxed are Italy and Germany where budget deficits have not exceeded 3 per cent of GDP.

Yet Italy has to also show that it has implemented structural reforms before any rules are relaxed-a requirement it does not currently meet. It is therefore very unlikely whether Germany will agree to any stimulus or relaxation and it is equally questionable whether it will accept QE given such failure. Such an explanation further suggests itself in Draghi’s own speech where he argues that any stimulus and rule relaxations can only “buy time” for the reforms.

To conclude, just as Germany accepted OMT in return for the fiscal pact, it may accept QE in return for structural reforms. But OMT- which targets specific government bonds – was never used precisely because of German opposition to any actual implementation. It should not be forgotten after all that the legality of the programme was challenged in the country’s Constitutional Court and QE is naturally more far-reaching than OMT.

Nevertheless, compared to other measures such as Eurobonds and a pan-European investment programme, QE is the only solution with any chance of attaining German support, especially given the political capital that has been invested in the euro. Such political support though may appear only when the eurozone economy enters the deflationary danger zone.

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