QE’ing the Can Down the Euro Road

Has Mario Draghi finally gone too far? With the 18-month program of asset purchasing — or quantitative easing (QE) — that began this week, the president of the European Central Bank (ECB) has de facto expanded the bank’s mandate: Together with price stability, economic growth is now ECB’s key concern. Draghi has deliberately moved the bank into more political territory, by pushing down interest payments for highly indebted countries. In doing so, the ECB is pushing up the prices of bonds eligible for the program. That’s a big risk for the ECB, and for the investors who intend to hold these bonds to maturity.

Even before implementing QE on March 10, the ECB’s ultra-loose monetary policy had already had some impact. The euro exchange rate against the dollar dropped by approximately 6 percent between the ECB announcement at the end of January and its implementation: The euro is now at 12-year low against the dollar. And the Eurostat consumer confidence index has gone up to -6.2 in February from -12.7 in December. This is good news — at least in the short term.

Economic recovery, especially in the euro periphery, remains modest, as does job creation. In Italy, for instance, GDP is projected to expand by just 0.8 percent this year. But stronger confidence, especially if sustained throughout the year, can do wonders for Europe’s battered economies. The question is whether governments will use this window of opportunity to push reforms that would improve the functioning of services markets, remove existing monopolies among some professional groups (notaries, for example), make the public sector more efficient, reduce the red tape, and modernize tax systems.

These are some of the reforms that countries like Italy and Greece, but also France and Germany, need to implement. The ECB’s QE buys political leaders time, but it remains to be seen whether they are prepared to use it — and a bit of political capital — to create consensus around the need for reforms. And even if they did, it’s hard to say if reform proposals could make their way through parliaments and, finally, to implementation. Indeed, the incentives to go through a painful process of change are not there, surely not in the short term. What the ECB seems to have done with QE is to provide a large carpet under which to sweep issues that require complex, long-term solutions that do not necessarily advance the political agenda of their proponents and might undermine their political ambitions.

Indeed, by buying more time for the euro in the short term, Draghi may have pushed any long-term solution further away. Fostering complacency is the implicit risk in the decision to extend the ECB’s safety net and to support economic growth in the eurozone, as opposed to just keeping prices in line with the agreed inflation target. Complacency has never been in Draghi’s frank and forceful vocabulary. But in reality, even if it correctly addresses the issue of medium-term growth, the ECB’s move limits the incentive to focus on what will happen to Europe’s single currency, the euro, in the longer term if member states are unable or unwilling to modernize their economies, make them more productive, and adapt to the constraints posed by the euro.

With the arrival of QE, the rebound of economic growth in the eurozone is firmly predicated on a weak euro (mainly against the dollar). But this won’t necessarily translate into balanced growth for all the eurozone’s member states. Instead, it could go towards improving the trade balance of countries with significant trade outside the eurozone, such as Germany. By lowering the price of extra-euro exports, QE could exacerbate the current imbalances within the eurozone by providing an extra competitive advantage to countries that are already competitive. Less competitive countries, on the other hand, will surely experience an increase in their exports outside the eurozone, but this will be limited by the size of their extra-euro markets and will not increase their competitiveness within the eurozone, where most trade happens, unless they do the necessary reforms.

In addition, countries in the region that are not part of Europe’s monetary union but that have their currencies somehow anchored to the euro — such as Denmark and Switzerland until mid-January — will find it increasingly difficult to manage the spillover impact of QE. As money flows into Europe’s non-euro markets in search of higher yields and stronger currencies, central banks are faced with the dilemma of whether to let their currencies appreciate — with the potential loss of competitiveness for exports — or to intervene in the foreign exchange market to manage the currency’s appreciation. The Danish central bank, for instance, has already spent a bit more than 100 billion kroner (13.4 million euros) to prevent its currency from rising against the euro, absorbing a record amount of euros in the process. In addition, it had to cut interest rates three times in 10 days in January. They are currently at -0.75 percent.

Financial fragmentation within Europe’s monetary union will also increase as a result of QE, enhancing differences in risk exposures, costs and gains, For instance, by purchasing securities within the QE program, national central banks of the eurozone have some flexibility on when to purchase and how to split the purchase between government bonds, agency papers, and international securities. This flexibility may lead to unequal shares in the program and imbalances in credit markets, with central banks that are more active ending up taking more risk.

If QE manages to support economic growth and fend off deflationary pressure, reducing the threat of protracted stagnation in Europe, then the ECB and its president will have put the eurozone back on track for a bit longer. However, the ECB needs political winds to blow their way in order to succeed. Without the reforms necessary to correct trade and financial imbalances within the eurozone, any growth will be driven, at best, by factors such as low oil prices and a weak currency. With or without QE, the fundamental question of different levels of productivity and thus competitiveness within the eurozone will continue to haunt the future of Europe’s single currency.

Photo by Hannelore Foerster/Getty Images