ECB strategy

Bonds Away!

ecb_bloomberg-DISTORTED
But will the sun still be shining on the ECB after the program?
  • Why it matters

    Why it matters

    The ECB’s proposed bond-buying strategy has the potential to re-energize Europe’s stagnating economy.

  • Facts

    Facts

    • The ECB is considering a mass purchase of government bonds.
    • Critics say the program will be ineffective and disincentivize root and branch reform.
    • The ECB is already battling low interest rates.
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    Audio

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It’s increasingly probable that the European Central Bank will embark on a program to buy huge amounts of government bonds, a process known as quantitative easing. This is arousing great fear in Germany.

Critics say it will be ineffective, hurt savers,  and stop governments from making much-needed reforms.

These worries are, for the most part, unfounded. Germans should be more concerned about the damage done to their own and other European economies if the ECB’s monetary policy fails.

An ECB program to purchase government bonds can be successful, if a series of conditions are met.

It will be very difficult to drop already very low interest rates for countries and function more like the U.S. Federal Reserve Bank’s second purchasing program after 2010.

An ECB program to purchase government bonds can be successful, if a series of conditions are met.

But the program will reduce the amount of available government bonds and can lower interest rates for private borrowing through a restructuring of portfolios, making credit loans by banks more attractive.

How well the mechanism works depends on whether the ECB is successful in building the confidence of market participants, investors and companies.

One way such confidence will be determined is by the ECB’s credibility. The importance of gaining trust can be seen in the ECB announcement of the Outright Monetary Transactions purchasing program in mid-2012, which prevented an economic collapse.

Today, the ECB is in a far more difficult starting position. It didn’t achieve its mandate of price stabilization and is increasingly losing its credibility, as documented by the lack of anchoring of the inflation rate expectations.

Every monetary policy measure takes time to develop. An ECB purchasing program must, therefore, be large and carried out with resolve to ensure credibility.

The success of the purchasing program doesn’t just depend on the ECB, but also on economic policy makers doing their bit. Criticism of many euro zone members for not implementing reforms is both cynical and wrong. Countries such as Spain, Portugal and Ireland have implemented far-reaching reforms that are showing distinctly positive results.

The political will to reform in France remains weak, but Italy is showing a clear commitment to major structural reforms. The concern that the ECB purchasing program could keep governments from undertaking necessary reforms is therefore overblown.

The program could be structured to give the ECB the flexibility to make purchases in countries and market segments where the need for monetary policy transfer is the greatest. However, this is difficult and hazardous.

The primary goal shouldn’t be to reduce differences in interest rates in government bonds that almost exclusively reflect different credit risks, but to improve market liquidity and conditions for private financing.

The most important prerequisites for the program’s effectiveness are its credibility and a stronger control of market expectations. This requires clear criteria and transparency for future bond purchases.

The most important prerequisites for the program’s effectiveness are its credibility and a stronger governance of market expectations.

An ECB purchasing program would not harm German savers, since nothing about low interest rates would change in the short term. On the contrary, a successful ECB monetary policy will help to overcome the European crisis more quickly, allowing interest rates for savings accounts to increase sooner.

German fears about excessive inflation also are unfounded, since the ECB can quickly neutralize its measures if necessary.

There is no guarantee of success for the government bond-purchasing program. It can be seen as a necessary evil or as opportunity. Despite the worries, however justified, it’s the best and last remaining option for the ECB to fulfill its mandate and protect its credibility. It will not harm the German economy, but rather be of use to it.

It is the job of society and political leaders — not the ECB — to pressure governments to implement urgently needed reform. And it is the job of politicians to support the ECB in its difficult task. A failure of ECB monetary policy means less employment and growth for Europe and Germany.

 

To contact the author: gastautor@handelsblatt.com

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