[Viewpoint] The big easing

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[Viewpoint] The big easing

More than three years after the fi-nancial crisis that erupted in 2008, who is doing more to bring about eco-nomic recovery, Europe or the United States? The US Federal Reserve has completed two rounds of so-called "quantitative easing," whereas the European Central Bank has fired two shots from its big gun, the so-called long-term refinancing operation (LTRO), providing more than 1 trillion euros ($1.3 trillion) in low-cost financ-ing to euro zone banks for three years.

For some time, it was argued that the Fed had done more to stimulate the economy, because, using 2007 as the benchmark, it had expanded its balance sheet proportionally more than the ECB had done. But the ECB has now caught up. Its balance sheet amounts to roughly 2.8 trillion euros, or close to 30 percent of euro zone GDP, compared to the Fed’s balance sheet of roughly 20 percent of U.S. GDP.

But there is a qualitative difference between the two that is more impor-tant than balance-sheet size: The Fed buys almost exclusively risk-free as-sets (like U.S. government bonds), whereas the ECB has bought (much smaller quantities of) risky assets, for which the market was drying up. Moreover, the Fed lends very little to banks, whereas the ECB has lent mas-sive amounts to weak banks (which could not obtain funding from the market). In short, quantitative easing is not the same thing as credit easing.

The theory behind quantitative easing is that the central bank can low-er long-term interest rates if it buys large amounts of longer-term govern-ment bonds with the deposits that it receives from banks. By contrast, the ECB's credit easing is motivated by a practical concern: Banks from some parts of the euro zone - namely, from the distressed countries on its periph-ery - have been effectively cut off from the inter-bank market.

A simple way to evaluate the dif-ference between the approaches of the world's two biggest central banks is to evaluate the risks that they are taking on. When the Fed buys U.S. govern-ment bonds, it does not incur any credit risk, but it is assuming interest-rate risk. The Fed acts like a typical bank engaging in what is called "ma-turity transformation" : It uses short-term deposits to finance the acquisi-tion of long-term securities. With short-term deposit rates close to zero and long-term rates at around 2 per-cent the Fed is earning a nice "carry," equal to about 2 percent per year on bond purchases totaling roughly $1.5 trillion over the course of its quantita-tive easing, or about $30 billion.

Any commercial bank contemplat-ing a similar operation would have to take into account the risk that its cost of funds increases above the 2 percent yield that it earns on its assets. The Fed can determine its own cost of funds, because it can determine short-term interest rates. But the fact that it would inflict losses on itself by increasing rates is likely to reduce its room for maneuver. Its recent announcement that it will keep interests low for an extended period thus might have been motivated by more than concern about a sluggish recovery.

By contrast, the ECB does not as-sume any maturity risk with its LTRO, because it has explicitly stated that it will charge banks the average of the interest rates that will materialize over the next three years. It does, however, take on credit risk, because is lending to banks that cannot obtain funding anywhere else.

The large increase in the ECB's balance sheet has led to concern that its LTRO might be stoking inflation. But this is not the case: The ECB has not expanded its net lending to the euro zone banking system, because the deposits that it receives from banks (about 1 trillion euros) are almost as large as the amounts that it lends (1.15 trillion euros). This implies that there is no inflationary danger, because the ECB is not creating any substantial new purchasing power for the bank-ing system as a whole.

The banks that are parking their money at the ECB (receiving only 0.25 percent interest) are clearly not the same ones that are taking out three-year loans at 1 percent. The deposits come largely from northern European banks (mainly German and Dutch), and LTRO loans go largely to banks in southern Europe (mainly Italy and Spain). In other words, the ECB has become the central counterparty to a banking system that is de facto seg-mented along national lines.

The real problem for the ECB is that it is not properly insured against the credit risk that it is taking on. The 0.75 percent spread between deposit and lending rates (yielding 7.5 billion euros per year) does not provide much of a cushion against the losses that are looming in Greece, where the ECB has 130 billion euros at stake.

The ECB had to act when the euro zone's financial system was close to collapse at the end of last year. But its room for maneuver is even more re-stricted than that of the Fed. Its bal-ance sheet is now saddled with huge credit risks over which it has very little control. It can only hope that politi-cians deliver the adjustments in south-ern Europe that would allow the LTRO's recipient banks to survive.Copyright: Project Syndicate, 2012.

* The author is director of the Center for European Policy Studies.

by Daniel Gros
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