After years of stalling, the European Central Bank (ECB) finally launched a meaningful quantitative easing (QE), or bond-buying program. ECB President Mario Draghi announced that the ECU will buy €60 billion, which at today’s rate is roughly equivalent to $69 billion dollars.
The program will begin in March and is expected to last through at least September 2016, which means that the ECB is expected to spend close to €1 trillion. If inflation expectations are still below their two percent target at that time, they indicated that the program would likely continue.
The basic idea behind a QE program is that central banks can provide monetary stimulus by lower long-term interest rates, which, in theory, encourages investment and other kinds of risk-taking. Since the central bank is essentially printing money and adding it to the money supply, the risk is that QE stokes inflation.
At this point, deflation is a much larger concern in Europe and the ECB is trying to increase inflation expectations, which are currently negative.
Germany is hypersensitive to inflation risks because they have suffered through terrible bouts of inflation in the past. During the Weimar Republic following World War I, hyperinflation took hold and by November 1923, one American dollar was worth 4.2 trillion marks (yes, that’s trillion with a ‘t’).
Wikipedia shows a picture of a five billion mark postage stamp and you may recall seeing old photos of Germans carrying wheelbarrows of cash to buy a loaf of bread or kids playing with blocks of bundled cash. Click here for some amazing photos.
Although the vast majority of the 25-member governing counsel at the ECB approved yesterday’s QE announcement, it was unanimous and we can safely assume that Germany’s two delegates opposed the program.
In addition to worrying about inflation, Germany is concerned that monetary stimulus will allow less stable countries in the union to put off fixing their own structural problems.
For example, Germany runs a budget surplus, meaning that their tax receipts cover all of the government spending. At the other end of the spectrum, the fiscal deficit for Greece equals roughly 12 percent of their gross domestic product (GDP). For comparison, the US deficit is roughly two percent of GDP.
Germany is worried that the monetary stimulus from the ECB will take the pressure off of Greece to cut spending or collect more in taxes to balance their budget.
The structure of this QE helps reduce the risk for Germany to some extent because the ECB won’t actually be doing the buying, the central bank from each of the 19 members will buy their own bonds: Germany will buy German bonds, Spain will buy Spanish bonds, etc.
If a government defaults, the impact will be felt by the central bank of that government. So, if Greece or Portugal defaults on their bonds, it means that the Greek central bank will be stiffed (and not the Germans).
This protection highlights one of the key difficulties that the Europeans face: their underlying differences. In the US, we can say that Texans are different than Californians and New Englanders, but we’re all Americans. That kind of unity simply doesn’t exist in the Eurozone.
So far, markets like the news. Government bond yields have fallen, stocks prices are up and the euro is down slightly – exactly what you would expect (or at least hope for).
The biggest relief for investors is that they did something, instead of making big promises and letting everyone down, like they have for the last few years. They also surprised the market with an extra €10 billion euros a month and indicated that it will last for some time.
These are all powerful messages that may help the program be effective.