As we saw in the blog post last month, Eurozone becalmed the doldrums, the eurozone economy is stagnant and there is a growing danger that it could sink into a deflationary spiral. Last month, several new measures were announced by the ECB, including a negative interest rate on money deposited in the ECB by banks in the eurozone. This month, the ECB has gone further including, for the first time, a form of quantitative easing.
So what has been announced, and will it help to kick-start the eurozone economy? The measures were summarised by Mario Draghi, President of the ECB, at a press conference as follows:
The Governing Council decided today to lower the interest rate on the main refinancing operations of the Eurosystem by 10 basis points to 0.05% and the rate on the marginal lending facility by 10 basis points to 0.30%. The rate on the deposit facility was lowered by 10 basis points to –0.20%. In addition, the Governing Council decided to start purchasing non-financial private sector assets.
The Eurosystem will purchase a broad portfolio of simple and transparent asset-backed securities (ABSs) with underlying assets consisting of claims against the euro area non-financial private sector under an ABS purchase programme (ABSPP). This reflects the role of the ABS market in facilitating new credit flows to the economy and follows the intensification of preparatory work on this matter, as decided by the Governing Council in June. In parallel, the Eurosystem will also purchase a broad portfolio of euro-denominated covered bonds issued by MFIs domiciled in the euro area under a new covered bond purchase programme (CBPP3). Interventions under these programmes will start in October 2014.
To summarise: the ECB has cut interest rates, with the main rate cut to virtually zero (i.e. 0.05%). This represents a floor to interest rates, as, according to Mario Draghi, there is now no scope for further cuts. (Click here for a PowerPoint of the chart.)
In addition, the ECB will begin the outright purchase of private-sector securities. This is a form of quantitative easing as it will involve the purchase of assets with newly created money. In the past, the ECB has simply offered loans to banks, with assets owned by banks used as collateral. This form of quantitative easing has been dubbed ‘QE light’, as it does not involve the purchase of government bonds, something the German government in particular has resisted. The ECB recognises that it would be a sensitive matter to buy government bonds of countries, such as Greece, Spain and Cyprus, which have been criticised for excessive borrowing.
Nevertheless, if it involves the creation of new money, purchasing private-sector assets is indeed a form of QE. As Mario Draghi said in response to a question on this matter:
QE is an outright purchase of assets. To give an example: rather than accepting these assets as collateral for lending, the ECB would outright purchase these assets. That’s QE. It would inject money into the system. Now, QE can be private-sector asset-based, or also sovereign-sector, public-sector asset-based, or both. The components of today’s measures are predominantly oriented to credit easing. However, it’s quite clear that we would buy outright ABS only if there is a guarantee.
So with appropriate guarantees in place about the soundness of these securitised assets, the ECB will purchase them outright.
But will these measures be enough? Time will tell, but there are now several measures in the pipeline, which could see a large stimulus to bank lending. The main question is whether banks will indeed take the opportunity to lend or merely hoard the extra reserves. And that depends in large part on the demand for credit from businesses and consumers. Boosting that is difficult when the economic climate is pessimistic.
Draghi’s ECB surprise puts off bigger quantitative easing for now Reuters, John O’Donnell (5/9/14)
ECB President Mario Draghi pulls stimulus lever at last, but still no quantitative easing for eurozone Independent, Ben Chu (5/9/14)
ECB cuts rates and launches stimulus programme BBC News (4/9/14)
Draghi Push for ECB Easing Intensifies Focus on ABS Plan Bloomberg, Stefan Riecher and Jeff Black (4/9/14)
Draghi Sees Almost $1 Trillion Stimulus as QE Fight Waits Bloomberg, Simon Kennedy (5/9/14)
Draghi’s Case For ECB Quantitative Easing Forbes, Jon Hartley (8/9/14)
ECB’s last roll of the dice BBC News, Robert Peston (4/9/14)
Draghi’s eurozone steroids BBC News, Robert Peston (2/10/14)
Draghinomics – Abenomics, European-style The Guardian, Nouriel Roubini (1/9/14)
ECB Press Release
Introductory statement to the press conference (with Q&A) European Central Bank, Mario Draghi, President of the ECB (4/9/14)
Webcast of the press conference 4 September 2014 European Central Bank, Mario Draghi, President of the ECB (4/9/14)
- Summarise the ECB’s monetary policy measures that will be coming into effect over the coming months.
- How does the QE announced by Mario Draghi differ from the QE that has been used by the Bank of England?
- Would it be a realistic option for the ECB to reduce its main rate below zero, just as it did with the deposit facility rate?
- What is meant by ‘securitisation’. Explain how asset-backed securities (ABSs) and covered bonds are forms of securitised assets.
- Why will the purchase of mortgage-backed securities not necessarily give a boost to the housing market?
- How does the effectiveness of any QE programme depend on what happens to the velocity of circulation of created money?
- What determines this velocity of circulation?
- Why are ‘animal spirits’ so important in determining the effectiveness of monetary policy?
- Are there any moral hazards in the ECB actions? If so what are they?
Each day many investors anxiously watch the stock market to see if their shares have gone up or down. They may also speculate: buying if they think share prices are likely to go up; selling if they think their shares will fall. But what drives these expectations?
To some extent, people will look at real factors, such as company sales and profits or macroeconomic indicators, such as the rate of economic growth or changes in public-sector borrowing. But to a large extent people are trying to predict what other people will do: how other people will react to changes in various indicators.
John Maynard Keynes observed this phenomenon in Chapter 12 of his General Theory of Employment, Interest and Money of 1936. He likened this process of anticipating what other people will do to a newspaper beauty contest, popular at the time. In fact, behaviour of this kind has become known as a Keynesian beauty contest (see also). Keynes wrote that:
professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgement, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.
When investors focus on people’s likely reactions, it can make markets very unstable. A relatively minor piece of news can cause people to buy or sell in anticipation that others will do the same and that others will realise this and do the same themselves. Markets can overshoot, until, when prices have got out of line with fundamentals, buying can turn into selling, or vice versa. Prices can then move rapidly in the other direction, again driven by what people think other people will do. Sometimes, markets can react to very trivial news indeed. As the New York Times article below states:
On days without much news, the market is simply reacting to itself. And because anxiety is running high, investors make quick, sometimes impulsive, responses to relatively minor events.
The rise of the machine
In recent years there is a new factor to account for growing stock market volatility. The Keynesian beauty contest is increasingly being played by computers. They are programmed to buy and sell when certain conditions are met. The hundreds of human traders of the past who packed trading floors of stock markets, have been largely replaced by just a few programmers, trained to adjust the algorithms of the computers their finance companies use as trading conditions change.
And these computers react in milliseconds to what other computers are doing, which in turn react to what others are doing. Markets can, as a result, suddenly soar or plummet, until the algorithms kick the market into reverse as computers sell over-priced stock or buy under-priced stock, which triggers other computers to do the same.
Robot trading is here to stay. The articles and podcast consider the implications of the ‘games’ they are playing – for savers, companies and the economy.
The Beauty Contest That’s Shaking Wall St. New York Times, Robert J. Schiller (3/9/11)
Speculative bubbles don’t just pop – they may deflate and reflate The Guardian, Robert Shiller (19/7/13)
A dark magic: The rise of the robot traders BBC News, Laurence Knight (8/7/13)
Stock markets under computer control BBC News, Robert Peston
Eunuchs of the Universe: Wall Street Today The Daily Beast, Tom Wolfe (4/1/13)
- Give some other examples of human behaviour which is in the form of a Keynesian beauty contest.
- Why may playing a Keynesian beauty contest lead to an undesirable Nash equilibrium?
- Does robot trading do anything other than simply increase the speed at which markets adjust?
- Can destabilising speculation continue indefinitely? Explain.
- Explain what is meant by ‘overshooting’? Why is overshooting likely to occur in stock markets and foreign exchange markets?
- In what ways does robot trading (a) benefit and (b) damage the interests of savers?
Both business and consumer confidence are affected by the state of the economy. A recession, or even a slowdown in the economy, will make people worried for their jobs and future incomes and hence cut back on spending and either save more or reduce their debts. Similarly firms are likely to cut back on investment if they are pessimistic about the future. But both consumer demand and investment are components of aggregate demand. A cut in aggregate demand will drive the economy further into recession and cause even greater pessimism. In other words, there is a feedback loop. Recession causes pessimism and hence a fall in aggregate demand, which, in turn, worsens the recession.
A similar process of feedback occurs in times of optimism. If the economy recovers, or is thought to be about to do so, the resulting optimism will cause people and firms to spend more. This rise in aggregate demand will help the process of recovery (see Accelerating the recession and Animal Spirits).
The following article by Robert Shiller, co-author of Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism, looks at the swing from pessimism to optimism over the past few months.
An Echo Chamber of Boom and Bust: Robert Schiller New York Times (29/8/09)
Efficient Market Hypothesis: True “Villain” of the Financial Crisis? The Market Oracle (26/8/09)
Monthly confidence indicators for the EU can be found at:
Business and Consumer Surveys: Time Series European Commission Directorate-General for Economic and Financial Affairs. (Each of the ‘en’ cells links to a zipped Excel file.)
- Explain why “confidence has rebounded so quickly in so many places” in recent weeks.
- Is Robert Shiller’s explanation of feedback loops consistent with the accelerator theory?
- In what circumstances do business and consumer psychology result in destabilising speculation and what causes turning points in the process? Why may such turning points be difficult to predict?
- Examine the monthly Economic Sentiment Indicator (ESI) for the UK from the ‘Business and Consumer Surveys: Time Series’ link above. You will need to refer to the final column in the Excel ESI Monthly worksheet (Column GV). Chart the movements in this indicator over the past three years. Also chart the quarterly growth in UK GDP over the same time period. You can find data from Economic and Labour Market Review (ONS), Data tables, Table 1.01, Column YBEZ. Is ESI a leading or a lagging indicator of GDP?
- What implications does Shiller’s analysis have for the management of the economy?
- Why may stock market movements not be a ‘random walk’?
The following articles look at a recently published book by George Akerlof of the University of California, Berkeley, and Robert Shiller of Yale. They examine the role of what Keynes called ‘animal spirits’ and is the title of the book.
The motivation to make economic decisions (to buy, to sell, to invest, etc) may not be ‘rational’ in the sense of carefully weighing up marginal costs and marginal benefits. Rather it can be one of over-optimism in good times or over-pessimism in bad times. Just as individuals have ‘mood swings’, so there can be collective mood swings too. After all, confidence, or lack of it, is contagious. This motivation that drives people to action is what is meant by animal spirits.
But are animal spirits a blessing to be nurtured or a curse to be reined in? Should governments seek to constrain them?
An economic bestiary The Economist (26/3/09)
Good Government and Animal Spirits Wall Street Journal (23/4/09)
Irrational Exuberance New York Times (17/4/09)
Animal Spirits: A Q&A With George Akerlof Freakonomics: New York Times blog (30/4/09)
- Describe what is meant by ‘animal spirits’ and their effects on human behaviour.
- Why may animal spirits make economies less stable?
- How may animal spirits help to explain exchange rate overshooting?
- Discuss whether governments should seek to constrain animal spirits and make people more ‘rational’? Also consider what methods governments could/should use to do this?