Europe’s QE quandary

Clive Crook

Inflation in the euro area fell to 0.7 percent in February, down a notch from January’s 0.8 percent. The news, announced this week, should have attracted more attention. The European Central Bank is persistently failing to meet its goal of keeping inflation “below, but close to, 2 percent.” It has the means to do something about this, but has decided not to act.

The situation demands further monetary easing - but with interest rates already very low, that presents a problem.

The ECB can’t easily adopt quantitative easing, which the U.S. Federal Reserve and the Bank of Japan have used to good effect, because its legal power to do so is disputed. Germany’s Constitutional Court referred the legality of Outright Monetary Transactions -a bond-buying program announced by the ECB but never deployed - to the European Court of Justice earlier this year, saying it believed the program to be illegal and wanted clarification from the higher court.

OMT is concerned with financial stability not monetary stimulus. But if OMT is illegal, then Fed-style QE would be too. Do these concerns over legality make sense?

Paul de Grauwe of the London School of Economics disputes it. He says the German court made two main arguments, both flawed.

First, according to the court, OMT overrides investors’ judgments about the right prices for distressed government bonds, and that’s not “monetary policy,” which the ECB is confined to, under the terms of its mandate. Second, OMT (like QE) exposes the central bank to the risk of losses that would ultimately be borne by taxpayers. This makes OMT a kind of fiscal policy - so again the ECB would be exceeding its powers.

De Grauwe says the first point is mistaken because the court is assuming that investors, left to themselves, would price bonds correctly. In fact, they don’t, and the central bank is acting properly if it intervenes to fix errors. On the second point, he acknowledges the risk of defaults that could deplete the central bank’s equity. But this isn’t a problem, he says, because central banks, unlike governments, can’t ever default. They can print money, so they don’t actually need any equity.

Europe needs OMT to be available, so it would be good if the European Court of Justice accepted De Grauwe’s arguments. Trouble is, his arguments aren’t that convincing.

The fact that the central bank might have good reasons to buy distressed bonds doesn’t bring such transactions within the realm of orthodox monetary policy: If that’s the test the law imposes, De Grauwe’s first argument isn’t much help. And his second argument - that central banks needn’t worry about sustaining losses - is too far-reaching. That view would justify plain vanilla direct financing of governments, where the central bank covers the government’s budget deficit and simply forgives the loans it makes in the process. Forbidding that practice was the whole point of the law defining the ECB’s powers.

The best way to legalize OMT and QE would be to give the ECB a new mandate - one that explicitly allows unorthodox monetary policy in emergencies. But that won’t happen, because the EU finds it harder to fix broken treaties than to adopt them in the first place. The European court, with luck, will fudge the issue, employing lawyerly ingenuity to justify ignoring the bad law as it stands. If that doesn’t happen either, there’s one more way to go.

Harvard’s Jeffrey Frankel tells Mario Draghi, the ECB’s president, you can do QE legally by buying U.S. bonds rather than the debts of EU governments. This doesn’t rescue OMT, because that program has to buy EU debt. But ECB purchases of U.S. debt would be a way to undertake QE within the bounds of the mandate.

And right now, the EU may need QE more than it needs OMT, because the threat of deflation looms larger than the danger of government defaults.

QE done this way usually goes by another name: unsterilized foreign-exchange intervention. It’s certainly within the ECB’s remit. It would ease monetary conditions in Europe both by expanding the money supply and by driving down the value of the euro.

As Frankel says:

“The strength of the euro has held up remarkably during the four years of crisis. Indeed the currency appreciated further when the ECB declined to undertake any monetary stimulus at its March 6 meeting.

The euro could afford to weaken substantially. Even Germans might warm up to easy money if it meant more exports rather than less. .?.?. As the Fed tapers back on its purchases of U.S. treasury securities, it is a perfect time for the ECB to step in and buy some itself.”

*The author is a member of the Bloomberg View editorial board.

By Clive Crook