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Friday, August 05, 2011

Could the ECB actually perform QE even if it wanted to?

Given the stock market free fall and bond market turbulence we’re seeing, the question over whether the ECB could actually embark on an effective round of Quantitative Easing (QE) has become a pertinent one. We’re not so sure it could (leaving aside the broader questions over how effective QE would be in any case [see US economy for details]).

First off, any increase in the monetary base of the eurozone requires the approval of the ECB Governing Council (GC), whether it is in hard currency (directly printing money) or electronically creating money (how QE is usually done). The GC is made up of the ECB executive board and the heads of each eurozone national central bank (NCB). The vote would be decided under QMV votes are weighted according to the level of capital shares each country has in the ECB. A majority is defined as two thirds of capital and at least half the members of the GC. So it would be a close run thing, but there could easily be enough opposition to halt any QE plan.

Secondly, even if any QE were approved, it would need to go through NCBs. The usual QE process is to deposit the funds directly into the reserve accounts which banks hold with a central bank or to purchase assets (probably government bonds) they hold via these accounts. Since these accounts do not exist directly with the ECB it would need to go through the NCBs (as per usual for monetary policy). So, all NCBs would need to enact the QE and to maintain the stability of the euro (so that new money is not just being created in excess in one area) the amounts would have to match up to the defined shares of the eurozone monetary base.

This means that Germany would actually have to enact a large percentage of the QE, in an economy which is growing solidly and is already becoming worried about inflationary pressures (particularly at current interest rates). Although, German domestic demand could do with a boost there is likely to be some inflationary effect of the QE if the transmission is effective. Even with the heavily interconnected banking sector in Europe it is unlikely that, given the current market pressures, money would easily flow around Europe to where it is most needed. Many banks continue to remain undercapitalised and are seeing profits squeezed by rising non-performing loans and the sovereign debt crisis. These are general problems with QE admittedly but are exacerbated by the structure of the eurozone making QE an ineffective tool in the eurozone.

As of right now, we still might be some way from an ECB bout of QE (although it’s closer than a few days ago). But, the ECB’s inability to perform what can be seen as a key tool in a central bank’s armoury highlights the structural problems for the ECB within the eurozone. In the longer term this could easily feed into market fears as we have been seeing with the heavily linked issue of lender of last resort.

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