Just a few days ago, the ECB announced through its president Mario Draghi that the Quantitative Easing is being extended until, at least, December 2017. In spite of a small reduction in QE (from €80 billion to €60 billion per month) this unconventional monetary policy remains as the primary strategy of the ECB to deal with the current economic situation. However, Quantitative Easing just does not seem to work, and the main problems highlighted by many economists for its failure are the following: first, the huge amount of non-performing loans owned by banks (especially in Italy) which led to more conservatism and therefore less investments despite the increasing amount of cash available to banks, second the lack of investments in both corporations and physical people mainly due to an high insensitivity even to low interest rates caused by a combination of actual lack of resources and fear.
The Problems With Quantitative Easing
Moreover, Quantitative Easing presents huge drawbacks which could make this unconventional monetary policy not only ineffective but also dangerous for the overall economy. The first drawback is the so-called bubble effect coming from the fact that QE can contribute to the creation of either a hard asset bubble or a financial bubble, potentially hitting both households and financial institutions. As a matter of fact, banks may undertake more risks with the proceeds they obtain from the central bank and rather than providing credit to firms and individuals they end up purchasing securities with a higher risk/reward profile (such as junk bonds) constituting a typical “moral hazard” situation, that could lead to enormous amount of losses if a bubble bursts.
Moreover, this potential bubble could burst and lead to price shocks if the operating central banks suddenly declare to taper QE and stop asset purchases. With the event of such bubble, two major problems would arise; interview the misallocation of capital to unproductive investments and collateral damages to the economy. These drawbacks state that QE policy could also have some dangerous side effects. Another major drawback could be that local European governments may avoid and postpone the undertaking of unpopular structural reforms because of the temporary relief that they think QE could give to their economies.
In the following quote, the Nobel Prize winner Joseph Stiglitz outlines one of the drawbacks of QE.
‘The dangers of negative interest rates — if you don’t manage it extraordinarily well; some countries are doing it reasonably well, some are not — is that it actually weakens the banking system, If it weakens the banking system, the banks are going to provide even less credit. While it might have some effect on financial markets, in terms of what we really should be concerned about, which is the flow of credit to businesses, that’s not working.’
Possible Improvements In QE
Many economists criticise this policy because of the weaknesses previously analysed and because only of its short-term benefits. Furthermore, they propose complementary or even alternative ways to QE, in order to solve the underlying problems of the economy, especially over the long run. A possible alternative policy, which could result in a more efficient economic result, is the so-called “Target Long-Term Refinancing Operation” (TLTRO). This policy, which was employed by the ECB in 2014, and consists in lending money to banks at a relatively low-interest rate (around 0,15%), but then obliging them to target their lending to families and businesses. Through TLTRO the real economy could be significantly affected by monetary policy. However, TLTRO was abandoned by the ECB because of its ineffectiveness in the short-term. Unfortunately, the short-term pressure is one of the reasons why monetary policies are preferred to fiscal policies in the short run. Finally, a last possible improvement could be an increase in international trade across the globe, which could both raise supply competitiveness and international investments, leading to economic improvements.
The German Effect
Moreover, intensification in R&D and education could, for example, increase productivity and revive the slowly growing economy. The country that should implement these policies more than any other is Germany. No one could easily disagree with two interesting reasons that Ben Bernanke (former President of the Federal Reserve) brought up (article: “Germany’s trade surplus is a problem, Ben Bernanke, Brookings Inc”) for which Germany’s trade surplus is now higher than ever. First of all, the QE that started in Europe at the beginning of 2015 has depreciated the euro on the dollar and other foreign currencies. This has significantly boosted exports in the euro countries and therefore it has remarkably expanded current accounts. This situation has especially advantaged Germany, which now has the highest trade surplus in the world on GDP, surpassing the exporting giant China. This is because the low currency value of the European monetary union does not reflect how the German economy is performing, thus allowing the country to keep trade strong without any risk of appreciation.
High in quality and competitiveness, the products from Germany could not be more attractive as the currency is so favourable. If Germany had a currency by itself, its value would be consistent with its country trade and therefore much higher than the euro current value.
Secondly, what pushes trade surplus further up is the fact that Germany is suppressing domestic spending, including on imports, which is exactly the opposite to what just previously opted as potential reinforcing policy. Nowadays the world economy is experiencing a dramatic shortage of aggregate demand, and the trade surplus of Germany could become an issue as it redirects demand away from other countries, therefore increasing unemployment and worsening their already tough economic situation.
The German government should then lead the way towards fiscal reforms by increasing its domestic investments and public expenditures (for example by cutting taxes, expanding infrastructures and increasing wages) to reduce not only its trade surplus but also its domestic unemployment (as the state requires workers to carry on infrastructure designing and construction). The improvements described above would force some firms to suffer from extra production costs in the short run, but this can only lead to an increase in domestic consumption and imports affecting both the national and foreign markets positively. Companies belonging to the rest of European Union could compete fairly with German firms, and Germany would benefit from public investments over in the future. Therefore, a combination of the current Quantitative Easing policy together with new structural reforms led by the German example could be a winning solution for the European crisis.