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.
Articles
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)
Questions
- 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?
In a statement to the House of Commons on 9 February 2011, the Chancellor announced that banks would extend their new lending to SMEs (Small and Medium-Sized Enterprises) from £179 billion in 2010 to £190 billion in 2011. An important question is the extent to which this initiative, which forms part of a series of initiatives in conjunction with the banking sector known as Project Merlin, will impact on economic activity.
Let’s begin by thinking about the role that credit plays in an economy. Firstly, it serves a short-term role by enabling individuals and firms to ‘bridge the gap’ between their income and their spending. Secondly, it can, depending on the size and terms of the credit, help to fund longer-term investments. In the case of firms, for instance, it can help to fund capital projects such as an expansion of premises or the installation of new equipment or production processes.
The extension of credit is the main source of growth in the money supply. If the credit which is extended by financial institutions is spent it increases economic activity. The size of the increase in economic activity will depend on how many times the credit is passed on from one firm or individual to the next. In other words, it depends on the velocity of circulation of money – often referred to simply as V. If the initial credit funds a series of purchases and the recipients of these monies, i.e. those from whom the purchases are made, then use their increased deposits to fund purchases themselves, the expansion could be sizeable.
There is every indication that the additional credit for SMEs will be welcome and it seems reasonable to assume that this will positively impact on spending. But, by how much is not entirely clear. This is what fascinates me about macroeconomics, but, perhaps understandably, may well frustrate others! Once the payments for the purchases made using the newly available credit become new deposits, how will these recipients respond? Will other credit-constrained firms use this liquidity to engage in purchases themselves? But, what if these recipients use the monies to increase or rebuild their own financial wealth? In this last scenario – a pessimistic scenario – the velocity of circulation will increase relatively little and economic activity little too.
The corporate sector, of course, does not exist in isolation of other sectors of the economy and, in particular, of the household sector. As some of the income from the expanded credit flows to them in the form of factor payments (i.e. wages and profits) – though by how much is itself debtable – how will they respond? Again will credit-constrained households look to spend? Alternatively, will they hold on to these liquid balances perhaps using them as buffer-stock savings? This is not an unrealistic possibility given the leverage of households and the need to rebuild wealth, especially so in times of incredible economic uncertainty? But, who knows!
So while Merlin may have waved his wand, the full extent of its impact, though probably positive, is far from clear. Time will tell. Isn’t macroeconomics wonderful!
HM Treasury Press Release
Government welcomes banks’ statement on lending by 15% more to SMEs, and on pay and support for regional growth, HM Treasury, 9 February 2011
Statement to the House of Commons by the Chancellor
Statement on banking by the Chancellor of the Exchequer 9 February 2011
Articles
Banks sign lending and bonus deal BBC News (9/2/11)
Banks agree Project Merlin lending and bonus deal BBC News (9/2/11)
Osborne’s plans arrive too late for the economy Independent, Sean O’Grady (11/2/11)
Project Merlin ‘could weaken UK banks’ Telegraph, Harry Wilson (11/2/11)
Nothing wizard about Project Merlin Guardian UK, Nils Pratley (7/2/11)
Softball: Britain’s banks make peace with the government – for now The Economist (10/2/11)
Smaller firms insist banks must change their attitude The Herald (11/2/11)
Questions
- Detail the various roles that financial institutions play in a modern-day economy.
- Do the activities of banks carry with them any risks? How might such risks be reduced?
- What is meant by the velocity of circulation or the velocity of money?
- What factors do you think could affect the velocity of money?
- How does credit creation affect the growth of the money supply?
- What do you understand by individuals or firms being credit-constrained?
- What factors are likely to affect how credit-constrained an individual household is?
- What do you think might be meant by buffer-stock saving? What might affect the size of the buffer-stock held by a household?
After the November 2009 meeting of the Monetary Policy Committee, the Bank of England announced that it would keep Bank Rate on hold at 0.5%, at which rate it has been since March. It also said that it would spend a further £25 billion over the next three months on asset purchases, primarily government bonds, thereby pumping additional money into the economy: the process known as “quantitative easing“. This would bring total asset purchases under the scheme to £200bn.
But although this represents a further increase in money supply, the rate of increase is slowing down. In the previous three months, £50 billion of assets had been purchased. So does this imply that the Bank of England sees a recovery around the corner? Will money supply have been expanded enough to finance the desired increase in spending – on both consumption and investment?
A problem so far is that most of the extra money has not been spent on goods and services. Banks have been building up their reserves, with much of the money simply being re-deposited in the Bank of England as reserve balances (see Table A1.1.1 in “Bankstats). At the same time, households have been taking on very little extra debt – indeed, In July, total household debt actually fell (see “Payback time) and consumer debt (i.e. excluding mortgages) has continued to fall. If quantitative easing is to work, the money must be spent!
But with the monetary base having expanded so much, is there a danger that, once the recovery gathers pace, spending growth will return with a vengeance? Will inflation rapidly become a problem again with an overheating economy? The following articles examine the issues.
Interest rates held at 0.5 per cent (includes video) Channel 4 News (5/11/09)
Bank of England extends quantitative easing to £200bn Guardian, Larry Elliott (5/11/09)
What the economists say: Quantitative easing £25bn boost Guardian (5/11/09)
Bank of England faced with its biggest split on policy in a decade Independent, Sean O’Grady (4/11/09)
Bank of England expands money-printing programme to £200bn to fight downturn (includes video) Telegraph (5/11/09)
The one thing worse than quantitative easing would be no QE at all Telegraph, Edmund Conway (5/11/09)
BoE: It ain’t over till it’s over Telegraph, Edmund Conway blog (5/11/09)
Bank raises stimulus to £200bn to end recession Times Online, Grainne Gilmore (5/11/09)
Bank of England to inject another £25bn of stimulus money Management Today (5/11/09)
Extra £25bn to stimulate economy BBC News (5/11/09)
Quantitative easing ‘not working’ (video of DeAnne Julius: former MPC member) BBC News (5/11/09)
Boxed in BBC Stephanomics (5/11/09)
The BoE’s £25bn gambit Financial Times, Chris Giles blog (5/11/09)
US to reduce Quantitative Easing as rates kept low Telegraph, James Quinn (4/11/09)
Quantitative easing ‘unpleasant’ BBC Today Programme, Stephen Bell and Wilem Buiter (7/11/09)
Experts debate whether quantitative easing is working (video) BBC Newsnight (6/11/09)
Questions
- What has been happening to the velocity of circulation of (narrow) money in the past few months? Explain the significance of this.
- What is likely to happen to the velocity of circulation in the coming months if (a) the economy recovers quite strongly; (b) recovery is modest?
- What is the relationship between quantitative easing and the growth in broad money (i.e. M4 in the UK)? How will banks’ desire to build up their reserves affect this relationship?
- Is the UK economy in a liquidity trap? Explain.
- Why is it likely that the Bank of England may well engage in more quantitative easing next March and beyond? How is the fiscal situation likely to affect Bank of England decisions?
- Examine the argument for the Bank of England buying more private-sector debt (virtually all of the asset purchases have been of public-sector debt)?
According to Brad DeLong, professor of economics at the University of California at Berkeley, if we are to get a full understanding of the financial crisis and recession of the past two years, we need to take a historical perspective. In the following article from The Economic Times of India, he argues that modern macroeconomists need to learn from history if their assumptions and models are to be relevant and predictive.
The anti-history boys The Economic Times (India) (1/10/09)
A fuller version of the above article, along with comments from readers, can be found on Brad deLong’s blog site, a Semi-Daily Journal of an Economist at:
Economic History and Modern Macro: What Happened? (30/9/09)
Questions
- According to Narayana Kocherlakota, most macroeconomic models “rely on some form of large quarterly movements in the technological frontier. Some have collective shocks to the marginal utility of leisure. Other models have large quarterly shocks to the depreciation rate in the capital stock (in order to generate high asset price volatilities)…”. How could these models explain business cycles? Would you classify them as ‘real business cycle theories’: i.e. as ‘supply-side’ explanations?
- How does Brad deLong explain recessions?
- Why does a change in the velocity of circulation of money contribute to a crash?
- What are the strengths and limitation of using economic history to understand the current crisis?
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.