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Deflationary QE

by afew Wed Jan 28th, 2015 at 02:02:50 AM EST

Along with Time for the ECB Board to be sacked and Another modest proposal, here's another take on what the European Central Bank is about to do.

In an article on Pieria, Frances Coppola looks at the reasons why the Swiss National Bank abandoned its euro floor, a knock-on effect of the ECB's QE announcement. She goes on to imagine that the SNB's floor was still in place, alongside the euro pegs of a number of other European countries outside the Eurozone. The ECB is about to create more than a trillion euros. What happens?

Lets All Play QE

It would create a flow system. I've talked before about leveraging flow systems in relation to bank lending and financial crises. But this is different. It's a deflationary flow system. This is how it works.

In the centre, the ECB pumps out Euros. Some of those Euros may stay in the Eurozone (we hope), increasing economic activity there. But as the Eurozone already has a trade surplus, so is a capital exporter, most will flow out to the Eurozone's trading partners, putting upwards pressure on their currencies. Those partners that have pegs to the Euro will quickly be forced to respond with monetary easing of their own in order to hold their pegs. So as the ECB pumps out Euros, ERM II central banks (and others) mop them up. The ECB exports deflation to its currency partners: those partners export it back to the Eurozone. The only inflation to be seen anywhere will be in central bank balance sheets. This is what the Swiss, who have one of the very few privately-owned central banks, fear.

Countries with euro pegs would not be the only ones concerned.

Lets All Play QE

As Kazakhstan could tell you, you don't have to have an official peg to a currency to find yourself importing the monetary policy of its issuer. All you need is strong trading links.

The result would be "games without borders" in which the Eurozone's close partners adopt monetary easing in response to the ECB's. And so:

Lets All Play QE

So far, the flow system as I have described it would simply inflate central bank balance sheets to no purpose. It wouldn't raise inflation and it would do very little to improve economic activity. This is the fallacy of composition to which I referred. Central banks do not operate alone. The consequences of their actions are felt by others, who defend against them. If the defence is successful, it negates much of the effect. When everyone is weakening their currency with interest rate cuts and QE, no-one can.

But why would this be deflationary, and not inflationary?

Coppola refers to an article by Francesco Giavazzi and Guido Tabellini on VoxEU:

Effective Eurozone QE: Size matters more than risk-sharing | VOX, CEPR's Policy Portal

QE increases aggregate demand through several channels:

  • Liquidity and portfolio effects.

There is general agreement that the effects through the first channel will be small. In many countries credit demand remains very weak. Capital rather than liquidity is the main constraint on banks, and interest rates are already very low.

  • Exchange rate effects.

The exchange rate channel is more important, but here too there are some doubts: the Eurozone is not a small open economy (external exports are only 20% of GDP) and the euro has already weakened considerably. This leaves the fiscal implications of QE as one of the most important channels to raise aggregate demand.

  • Fiscal implications.

As explained by Buiter (2014), when a central bank engages in QE it exchanges government debt for money, which is a non-redeemable liability. This relaxes the intertemporal government budget constraint. The reduction equals the full amount of QE - if the debt is held permanently. The reduction equals the interest payments - if debt is held only temporarily held or it is not rolled over at maturity.

This immediately implies that the fiscal consequences of QE are directly related to the duration of the balance sheet expansion of the central bank. A long-lasting expansion can be achieved by purchasing long-term debt and holding it until maturity, or rolling over the debt purchased.

Even if consumers are Ricardian, the relaxation of the government budget constraint leads to an immediate expansion of aggregate demand - if the expected path of future government spending remains unaltered. This expansion comes because consumers spend more in anticipation of their now larger permanent-disposable-incomes. If, as is plausible, Ricardian equivalence does not hold, the expansion of aggregate demand can only occur if the government exploits the additional fiscal space created by QE to run a larger deficit, through tax cuts or spending increases.

Hence, QE can be a powerful tool to stimulate aggregate demand. Just like `helicopter money', these direct expansionary effects do not rely on portfolio adjustment, liquidity effects, or exchange rate movements (Reichlin et al. 2013).

  • The key is that QE needs to be coordinated with fiscal policy and have permanent or long-lasting effects on the size of the central bank balance sheet.

As we might have expected, the ECB's money creation (or at least, most of it) won't find its way into the real economy any more than the ECB's previous liquidity operations did. Exchange rate effects will be minimal too. Only if there were a change in the Eurozone's fiscal stance could QE result in a significant rise in aggregate demand. Dream on.

Lets All Play QE

if all three channels are blocked, as they seem to be, then QE will be ineffective. And ineffective QE combined with fiscal austerity is deflationary. So this is a deflationary flow system - not an acute, Fisher-type deflationary spiral, but a slow burn.

Can anyone point out the flaws in this argument and give us all a nice warm feeling for the rest of 2015?

See my comment in the Newsroom:


Benoît Coeuré (French member of the ECB Board), interviewed this morning on radio France Inter, said that the aim was to push inflation towards the 2% target. But that German insistence on debt reduction and reforms was entirely justified, and these should be conducted simultaneously with pro-inflation measures.

He also said he knew the formula for turning lead into gold, but he wasn't telling.

ECB Board member tells us QE is going to restore the 2% inflation target while the fiscal stance will be maintained, along with "competitiveness reforms" that mean reduction of wages. These guys are the last alchemists indeed.

by afew (afew(a in a circle)eurotrib_dot_com) on Sun Jan 25th, 2015 at 05:31:50 AM EST
One of the problems I have always had with the ECB NOT pursuing QE earlier was that the EZ was effectively importing deflations from those economies which DID pursue QE - i.e. USA and UK - whose currencies where devalued relative to the Euro as a result.

I am more optimistic now because:

  1. QE has ended in US and UK so the earlier deflationary impact will be reversed
  2. Reduced Oil prices will improve disposable income and consumer expenditure in EZ
  3. Further devaluation of Euro will improve exports/reduce imports and make EZ a more attractive destination for FDI.
  4. Reduced Government debt service interest costs will increase Government expenditure by those Governments not ideologically wedded to austerity or facing general elections - e.g. Ireland, which has already angered European Commission by increasing expenditure/reducing taxes more than EC likes.
  5. A general election victory for Syriza which will will swing the political momentum from an ever increasing lurch to the right, and will also expose many of the shibboleths of austerity ideology.  Essentially Germany's bluff is being called.
  6. The combined effect of the above five factors will encourage the return of the "confidence faery" and increase the "feel good factor" amongst consumers and investors more generally.

I'm not saying it will be all plain sailing, but on balance I am an optimist that things will improve for the next 2 years at least - and QE directly will probably only be a minor contributory factor to that trend.

Index of Frank's Diaries
by Frank Schnittger (mail Frankschnittger at hot male dotty communists) on Sun Jan 25th, 2015 at 10:45:34 AM EST
  1. I understand Coppola to be saying QE generalises deflation: "The ECB exports deflation to its currency partners: those partners export it back to the Eurozone."
  2. & 3. Oil prices may go even lower, and that is a genuine (but small) boost to purchasing power of ordinary people. Though the more the euro devalues, the less the oil price effect.
  3. Reduced interest costs may give a little leeway to government budgets.
  4. Is what we hope. But expect a full court press from the other side. The rentiers will not loosen their grasp, and they pwn the media.
  5. I pray to the confidence trickster fairy every night. Then I have nightmares.

There may be a slight improvement for a time, but stagnation is on the cards for longer.
by afew (afew(a in a circle)eurotrib_dot_com) on Tue Jan 27th, 2015 at 05:58:14 AM EST
[ Parent ]
  1. Within a currency zone and its linked currency partners, maybe, but not wrt the rest of the outside world:  The EZ will be exporting deflation to USA, UK and the rest of the world, reversing the earlier trend.

  2. Yes this will be a key battle. Some German bankers have already been quoted as saying they expect Syriza to default/renege on their election promises.  I hope they are in for a shock.

Partly because of its demographics and age profile and partly because of the continuing erosion of its leadership position in the world, Europe has long been and will continue to be a low growth zone. Call it secular stagnation if you wish. However I am optimistic we will see an uptick in the business cycle for the next two years at least (always subject to unexpected shocks) and who knows after that.  

It should be noted, however, that the beneficial effects of QE, devaluation, and even lower oil prices and interest rates are to some extent once off which can kick start a recovery but not change longer term growth averages. I am predicting a cyclical upturn, not a fundamental shift in economic performance - unless we see Syriza kick starting a democratic revolution throughout the EZ. Not impossible, but unlikely, I would have thought.

Index of Frank's Diaries

by Frank Schnittger (mail Frankschnittger at hot male dotty communists) on Tue Jan 27th, 2015 at 09:15:07 AM EST
[ Parent ]
markets are getting this right...

But, at least the initial reaction to ECB QE is expected inflation in the near and mid term is up roughy 20 basis points.

He may be right but that isn't the market's reaction at present.

The Hun is always either at your throat or at your feet. Winston Churchill

by r------ on Mon Jan 26th, 2015 at 12:15:26 PM EST

It's Frances Coppola, not Francis Ford Coppola.

A society committed to the notion that government is always bad will have bad government. And it doesn't have to be that way. — Paul Krugman

by Carrie (migeru at eurotrib dot com) on Tue Jan 27th, 2015 at 05:30:12 AM EST
[ Parent ]
I want to see the helicopter scene in her "Monetary Apocalypse Now".

It is rightly acknowledged that people of faith have no monopoly of virtue - Queen Elizabeth II
by eurogreen on Tue Jan 27th, 2015 at 11:06:38 AM EST
[ Parent ]
I love the smelling of quantitative easing in the morning? They have to change the Wagner though - perhaps somthing from Rheingold?
by IM on Tue Jan 27th, 2015 at 11:23:06 AM EST
[ Parent ]
by IM on Tue Jan 27th, 2015 at 02:51:16 PM EST
[ Parent ]
QE has been carried on in the US and UK for a considerable enough length of time, and inflation is conspicuous by its absence. So I'd suggest the markets are running on standard CW, money-printing -> inflation.
by afew (afew(a in a circle)eurotrib_dot_com) on Tue Jan 27th, 2015 at 05:38:42 AM EST
[ Parent ]
Krugman argues that the main benefit of QE is that it increases inflation expectations, not necessarily inflation itself in any direct or immediate sense. So Redstar is correct in pointing to the increase in inflation expectations post the QE announcement (as Krugman has also done). Krugman also points out the fallacy of "runaway inflation" fears that opponents regularly cite - saying most of the money will end of sitting in bank accounts/vaults, having little effect on real economic activity or anything else.

Thus the economic benefits of QE are very marginal at best especially as interest rates approach the zero bound.  We have reached the limits of what monetary policy can do.  What QE CAN do - as pointed out by Stiglitz below, and by Chris Cook in relation to oil prices - is to create asset price and commodity price bubbles - as  investors/rentiers search desperately for ever more exotic instruments to generate a return.  

These can cause a contraction in the real by economy by increasing costs/making it less attractive to invest in productive activity here - but I expect that to become more of a problem further down the business cycle.  At the moment increased (say) houses prices are encouraging an increase in construction activity which (in Ireland at any rate) is still way below the historical average that is required given demographic trends.

Index of Frank's Diaries

by Frank Schnittger (mail Frankschnittger at hot male dotty communists) on Tue Jan 27th, 2015 at 09:34:11 AM EST
[ Parent ]
I'm skeptical of the impact of QE in general.  The studies I've read suggest it has a slight positive contribution to growth and inflation, but not much.

There's probably a small consumption effect as the Fed/BoE buy bonds at higher and higher prices and stuff cash into the pockets of investors.  But investors have very low propensities to consume.

Pushing down corporate bond yields probably helps to induce some investment, although direct spending and tax cuts to jack up demand would be much more effective.

To be honest, I'm not seeing much by way of bubbles that wasn't there before QE began.  And investors piling out of T-bills and corporate bonds in favor of gold and oil probably has little impact on the real economy.  As I said in Chris's thread, I don't think his picture with its "perfect correlation" shows any such thing.

I think the price swings in oil are more a function of expectations of future fundamentals and panic-buying and -selling than anything.  You can buy all the oil you want, but if it's not sold in sufficient quantity, inventories pile up and the market crashes.  The ones on his chart look to me like a visual representations of the market's reactions and corrections related to the various false dawns we've gone through since the recession ended.

Be nice to America. Or we'll bring democracy to your country.

by Drew J Jones (pedobear@pennstatefootball.com) on Tue Jan 27th, 2015 at 05:06:49 PM EST
[ Parent ]
It is plausible that the rebound of commodity prices after October, 2008 was funded largely by QE. It would require a detailed stock and flow analysis in order to demonstrate that thesis, and, somehow, that information is not available to the mortal man, and only partially available to to the demi-gods who are the inside regulators for the NY Fed. Carmen Segarra showed very clearly just how well that works for the public interest.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Wed Jan 28th, 2015 at 09:56:00 AM EST
[ Parent ]
Lots of things are plausible.

A stock and flow analysis isn't going to get you there.  That's still just storytelling.  You need a statistical analysis to suggest causation.

Be nice to America. Or we'll bring democracy to your country.

by Drew J Jones (pedobear@pennstatefootball.com) on Wed Jan 28th, 2015 at 02:00:12 PM EST
[ Parent ]
The Politics of Economic Stupidity by Joseph E. Stiglitz - Project Syndicate

For the past six years, the West has believed that monetary policy can save the day. The crisis led to huge budget deficits and rising debt, and the need for deleveraging, the thinking goes, means that fiscal policy must be shunted aside.

The problem is that low interest rates will not motivate firms to invest if there is no demand for their products. Nor will low rates inspire individuals to borrow to consume if they are anxious about their future (which they should be). What monetary policy can do is create asset-price bubbles. It might even prop up the price of government bonds in Europe, thereby forestalling a sovereign-debt crisis. But it is important to be clear: the likelihood that loose monetary policies will restore global prosperity is nil.

by afew (afew(a in a circle)eurotrib_dot_com) on Tue Jan 27th, 2015 at 02:36:27 AM EST
But at least, QE does not increase the problems...
by Xavier in Paris on Tue Jan 27th, 2015 at 05:58:04 AM EST
[ Parent ]
Coppola is saying it accentuates deflation.
by afew (afew(a in a circle)eurotrib_dot_com) on Tue Jan 27th, 2015 at 05:59:07 AM EST
[ Parent ]
I remember an article in FT last month in which several fund managers were predicting the results of the end of QE.  All were predicting big recoveries and moderate inflation, except for Jan Dehn at Ashmore, who was predicting disastrous inflation.  I remember thinking at the time, "These guys are being paid a lot of money to give opinions via manure spreaders."  Given that QE has been propping up commodity prices (See Chris Cook's "Thousand Words" diary.), that demand is going nowhere (Wages are still stagnant, and there is only so much debt people can absorb.), and austerity will continue to wind its counterproductive way through everything for the foreseeable future, where is the recovery supposed to come from, and what will be the cause of any inflation?
by rifek on Tue Jan 27th, 2015 at 03:17:50 PM EST
I suspect QE to be a mirror extension of austerity. The sly purpose of either of them is to address the ridiculous balance of financial obligations, I guess. Just as the 2008 bailouts, QE is channeling money through "ordinary" participants of the financial market to the real winners. Without QE, the "ordinary" participants would already be massively owned by the winners. This way QE is keeping the impeccably clean image of financial obligations. On the other hand, QE cannot mask the disparity of financial obligations and real world productivity forever. That is where austerity comes in, silently securing real resources (or at least, the relative position) for the winners.

The end game might be very near. One more shock act, just before Greece executes its brave stand perhaps, and the civilization falls apart into (prepared in advance) fiefdoms of current financial overlords.

by das monde on Wed Jan 28th, 2015 at 12:46:52 AM EST
The Stages of the Plan:

  1. Collect underpants
  2. ....
  3. ....
  4. Make civilisation collapse
  5. Profit!!!
by afew (afew(a in a circle)eurotrib_dot_com) on Wed Jan 28th, 2015 at 01:51:50 AM EST
[ Parent ]
6. Rule (when profiting have no realistic meaning)
by das monde on Thu Jan 29th, 2015 at 02:57:45 AM EST
[ Parent ]
ECB's Bond Purchases Will Bring U.S. Closer to Raising Rates - Bloomberg

Dollar bulls say Europe's 1.1 trillion euro ($1.24 trillion) bond-buying plan will bring the Federal Reserve a step closer to raising interest rates before the year's out.

By pumping cash into global markets, the European Central Bank may clear the way for the U.S. to tighten its own money supply without stoking volatility, according to Citigroup Inc. and Bank of America Corp. As Fed officials start a two-day policy meeting, the greenback is extending a rally that's taken it to a more than decade-high versus a basket of its peers even as bond investors express less conviction about the timing of an U.S. central bank's first rate increase since 2006.

"We've been expecting dollar strength, and it's coming quicker than we thought," Steven Englander, the head of Group of 10 foreign-exchange strategy at Citigroup in New York, said by phone on Jan. 23. Fed officials "may feel they actually have to advance the first tightening rather than put it off."

by afew (afew(a in a circle)eurotrib_dot_com) on Wed Jan 28th, 2015 at 01:55:27 AM EST

Lets All Play QE

The Eurozone's closest trading partners include several countries whose currencies float with respect to the Euro. Although their currencies will adjust, the effect will be local monetary tightening in countries many of which are already experiencing deflationary pressures due to the falling oil price. It would be entirely understandable if they also responded by easing monetary policy.

The US could be a case in point, but is tightening, not easing?

by afew (afew(a in a circle)eurotrib_dot_com) on Wed Jan 28th, 2015 at 02:00:39 AM EST
[ Parent ]
With the $ rising to record levels - in recent years - why would the FED add to this revaluation - which should reduce import prices and hence inflation - by tightening monetary policy?  If they are worried about the prospect of inflation and want to deflate a little, this re-valuation should do the job for them.

Index of Frank's Diaries
by Frank Schnittger (mail Frankschnittger at hot male dotty communists) on Wed Jan 28th, 2015 at 05:22:02 AM EST
[ Parent ]
If anything, QE is a form of competitive devaluation

Index of Frank's Diaries
by Frank Schnittger (mail Frankschnittger at hot male dotty communists) on Wed Jan 28th, 2015 at 05:26:49 AM EST
[ Parent ]
The end of Coppola's article:

Lets All Play QE

The IMF's Articles of Association explicitly rule out manipulation of exchange rates to benefit local exporters:

Each member shall:.....

(iii)avoid manipulating exchange rates or the international monetary system in order to prevent effective balance of payments adjustment or to gain an unfair competitive advantage over other members;

(IMF Article IV: Obligations Regarding Exchange Arrangements)

I fail to see how a QE programme that has as its explicit objective the weakening of the currency to benefit exporters can be seen as anything other than deliberate currency manipulation in contravention of this international agreement. And I also fail to see how weakening a currency in response to QE by a major trade partner can be seen as anything other than deliberate currency manipulation, either, although it is perhaps understandable.

Why is the IMF tolerating the nascent currency wars in Europe and Asia, I want to know?

Except that the US is not weakening but tightening... The US, of course, is an importer, not an exporter.

by afew (afew(a in a circle)eurotrib_dot_com) on Wed Jan 28th, 2015 at 05:57:40 AM EST
[ Parent ]
he US, of course, is an importer, not an exporter.

Bingo.  We're even a food importer now (perhaps the most disgusting joke I've ever heard).  We've stripped our ability to produce anything other than paper and electrons down to effectively nothing, so of course we want hard money so we can buy what everyone else is selling.  Of course, that hard money policy also means there is no domestic growth, the huge private debt gets farther out of control every month, and wealth continues to transfer to the rentier class by the freighter-load.  The US is charging headlong into the 14th Century.  All we need is a good, old-fashioned plague.

by rifek on Wed Jan 28th, 2015 at 01:50:32 PM EST
[ Parent ]
It can be argued that devaluation is an unintended indirect consequence of QE - as opposed to the direct maintenance of a currency cap or peg - as the Swiss did until recently - through buying and selling Euros. So this seems a Treaty obligation more honoured in the breach.

Index of Frank's Diaries
by Frank Schnittger (mail Frankschnittger at hot male dotty communists) on Wed Jan 28th, 2015 at 07:26:49 AM EST
But given the limited (at best) direct economic effects of QE, the (foreseeable, and anticipated by the market) depressed exchange rate seems to be the main benefit to the EU. Hard to get away with "unintended consequence".

It is rightly acknowledged that people of faith have no monopoly of virtue - Queen Elizabeth II
by eurogreen on Wed Jan 28th, 2015 at 01:18:29 PM EST
[ Parent ]
No the main effect of QE is to increase credit availability and reduce retail interest rates - currency devaluation is an indirect effect - certainly compared to the explicit currency cap operated by the Swiss National Bank - who btw are also an IMF Treaty signatory

Index of Frank's Diaries
by Frank Schnittger (mail Frankschnittger at hot male dotty communists) on Thu Jan 29th, 2015 at 10:36:48 AM EST
[ Parent ]
It is true that QE reduces cash flows out of the public sector. However, to conclude from this that QE is deflationary is a mistake: QE takes cash flow away from people who are long Treasury bonds - the very people who have the lowest propensity to spend.

As such, the fiscal effect should be expected to be negligible.

And there is a (more than) countervailing distributional effect, away from people who are long in private bonds and toward people who are short in private bonds. In other words, out of the hands of people who have proven that they tend to stuff money under a mattress and toward those who spend it productively.

This distributional effect, from the spread in marginal propensities to spend, is likely to overshadow the very limited negative fiscal effect.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Wed Feb 4th, 2015 at 01:34:14 PM EST

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