The ECB and QE: In defence of the Bundesbank

As deflation fears intensify in the Eurozone and euro area economic activity continues to be very weak, the question of what more the European Central Bank can or should do, and specifically whether it should engage in Quantitative Easing, or QE, becomes ever more urgent. It dominated, for example, the most recent ECB statement on 6 November and the subsequent press comment. And latterly it has become common practice to characterise the debate as being between the activists, led by ECB President Mario Draghi, and the doubters, led by Bundesbank President Jens Weidmann.

In the media the activists are portrayed as straining every sinew at their disposal to fight off deflation and revive economic activity in the euro area, while the doubters are shown as pursuing a more cautious approach, raising legalistic objections to the very idea of QE and expressing concern that even if it was legal it would not be effective or wise.  And, inevitably, if the ECB is seen to be moving closer to some form of QE, as was the case in the November statement, this is portrayed as a “victory” for Draghi and an implied “defeat” for Weidmann and the Bundesbank.

That this paints the Bundesbank in a very negative light, as the bank that likes to say No, will worry Weidmann and his colleagues not one bit. That it has called into question their judgment is potentially more damaging.  This essay will seek to explore the Bundesbank’s “case against” QE, to assess whether their concerns are legitimate.

Ever since Draghi’s famous statement in the summer of 2012 that “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro”, the question of whether “whatever it takes” includes QE for the Eurozone has been on commentators’ minds.  QE has been tried by three other major central banks, the Federal Reserve, the Bank of England and the Bank of Japan, and while the long term consequences of such unconventional monetary policy are still unclear and may yet be damaging for the financial system (and indeed for central banks themselves – see our earlier essay “The outlook for Unconventional Monetary Policy and the future of central banking”, 13.05.13), in the short run QE does appear to have had some beneficial effect on the US and UK economies at least.  And, observers say, it is surely therefore worth a try in the Eurozone as well.

The pressure on Draghi and his colleagues has if anything increased of late, as other recent initiatives that the ECB has tried have proved insufficient to halt the deterioration in the Eurozone economy. The most recent of these was a programme of purchases of covered bonds (a form of asset-backed securities); but the take-up was small and already there is talk of extending the purchase programmes to include corporate bonds as well.  And if corporate bonds, people ask, why not government bonds too?  In other words, why not try full-blown QE?

The first comment is that arguments along the lines of “The ECB must do something; QE is something; therefore the ECB must do QE” are unlikely to persuade any central banker, whether from the Bundesbank or anywhere else!

More seriously, central bankers are very conscious of the danger of “mission creep”, and the ECB has always been clear that its focus is on monetary stability and the health of the European financial system, especially its banks. In particular, the ECB is not the Federal Reserve and does not share the latter’s “dual mandate”, with its specific reference to the duty of the central bank to set policy so as to “promote … maximum employment”. This does not mean that the ECB is indifferent to the depressed state of Eurozone economic activity, but the Bundesbank is not alone in seeking to distinguish between impediments to economic growth that stem directly from failings of the financial system, which are clearly within the ECB’s remit, and impediments due to other causes, which are more likely to fall to other agents to resolve.

So the first of the Bundesbank’s concerns about QE is “What is it designed to do?” Is it to rectify a flaw in the financial system and the money transmission process, or does it have wider and – to some – less obviously appropriate objectives?

The second question that the Bundesbank and others raise is “What will it achieve?” And here it is not at all obvious that there is much advantage in buying government bonds when those bonds are already at record low yields.  10-year German government bonds already yield well under 1%, while 10-year Spanish bonds yield less than the equivalent maturity US Treasuries.  How exactly, comes the question, would buying these bonds and driving their yields even lower have any effect?

Thirdly, there are concerns over the side effects of buying government bonds. To many, the Eurozone government bond market is already approaching bubble status, with yields no longer reflecting reality, and the fear is that any ECB purchases would merely exacerbate this.  In the short term, this would further distort markets, while longer term it might increase financial risk and the danger of a hard landing when the bubble bursts.

Lastly there is the effect on the ECB itself, and its balance sheet. Buying bonds outright at such low yields would expose the ECB to capital losses if yields corrected to more normal and higher levels.  And as the Bundesbank observes, if those losses are large enough it risks depleting the ECB’s capital to a point at which it would need to be replenished.

And it is this of course that rings the legal alarm bells, because recapitalisation of the ECB would be a fiscal act, requiring taxpayers’ money to be expended. And, so the argument goes, the ECB does not have the authority to undertake actions with fiscal consequences, even potential ones.  This is one of the key points that have led to the legal challenges in the German Constitutional Court, and the referral to the European Courts for a ruling.  But these challenges are being led by others in Germany, not the Bundesbank.

So it is a simplification to paint the Bundesbank as merely the bank that says No, or as a legalistic quibbler. They have legitimate concerns over the objectives of QE, the operation of QE, the effectiveness of QE and the long term consequences of QE – both for the financial system and for the ECB itself.

And beyond all those, they have doubts that the ECB is the right agent to tackle the entirety of the Eurozone’s economic issues or that monetary policy is the right tool to use to do so. As Weidmann himself has observed, the ECB cannot be expected to fix all of the Eurozone’s problems and it should not be pushed into trying to do so, as this risks monetary policy being asked to deliver something it cannot.  And on this, one increasingly senses that Weidmann and Draghi, with his recent repeated calls on the political class to act, are not opponents but side by side.

Let us return to Draghi’s statement in mid-2012. What everyone remembers is the magic phrase “whatever it takes”.  One can trace the easing in the acute crisis over the euro and its very survival to the moment Draghi said this, and few pronouncements by any central bank governor at any time have had such an immediate and dramatic effect as these three words.

But the full quote, “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro”, sets out two important limitations.  The ECB is committed to preserving the euro, not to mending the Eurozone’s economic woes in general.  And those other three important words, “within our mandate”, may yet rule out full scale Eurozone QE.