International Financial Stability

By: Nick Peckham

Abstract:

During times of financial crisis and slow recovery, governments and central banks are more likely to use experimental and innovative policy. One of the policies sitting on the cutting edge of central bank manipulation is quantitative easing. This year, the European Central Bank extended their QE program, making the study of this topic extremely timely. What makes the study of QE programs so interesting is that the results are not 100% conclusive, and experts still disagree if it can be effective. In my paper I collected data from the European Central Bank and other financial data institutions, such as the IMF, in order to test if QE has been effective in Europe. I used a number variables to test the “effectiveness” such as changes in inflation and the change in 10 year treasury bond yields. While the results varied, it is important to note how recent the program is to the the ECB. With a less than ideal sample size, the results should be taken with a grain of salt. As time goes on and more data is compiled, a more fair analysis can be conducted.

 

Introduction and Background:

During the global financial crisis of 2008, the European Central Bank suffered from extreme financial turmoil. European countries experienced increased unemployment, an increase in government deficit, unstable measures of both deflation and inflation and a greatly reduced gross domestic product. The effects the crisis had on the ECB and European governments were long lasting and as a result, wreaked havoc upon  eurozone economies and of most of the world, including the United States. The European Central Bank acted quickly in their analysis and diagnosis of the economic challenges facing Europe and the world. During a 2009 speech, the current ECB president, Jean-Claude Trichet, gave a speech in Sofia, Bulgaria outlining the causes of the financial crisis while explaining Europe’s plan of attack going forward. His goal was to limit and put a stop to the financial pain the Eurozone was experiencing as a result of the crisis.

Trichet claimed the crisis was a result of a changing financial system. He explained that rather than managing risk and keeping responsible investments, investors turned to a system that assumed more risk, and actually valued it. The new system in place prized itself on speculation and creating risky financial endeavors that yielded high results when successful, but were catastrophic when not. Trichet explained that because the financial system had become so dependent upon the “intentional exposure to asset price changes” it had become vulnerable to crises like the one the world was facing (Bank, 2009). With this in mind, Trichet set out his plan on how the ECB would respond to the economic fallout. The first step in the plan was to cut interest rates by the largest number ever in such a small period of time. The interest rate set by the ECB was reduced by 325 basis points from October 2008 to June 2009. The ECB also aimed to ease inflationary pressures, as Trichet asserted that the ECB’s long standing inflationary target of 2% “has proven to be an invaluable asset” due to the instability the ECB faced when dealing with inflation (Bank, 2009). A number of other unconventional measures were used in attempting to bring back the Eurozone economies, including measures such as: adopting a regular refinancing option, expanding a list of assets the ECB can accept as collateral, and finally, including the European Investment Bank as a partner in the eurozone’s monetary policy operations. (Bank, 2009).

Even with the actions taken by the ECB, the crisis was so great that most measures made minimal impact. The financial crisis was so widespread and so impactful that even now, most countries have not fully recovered. The policies implement by the ECB were able to calm the fire a bit, but much of the damage had already been done. As a result of the policies enacted, the declining slope of the GDP tapered off. However, the overall growth of the Eurozone economies have  yet come to back to an ideal growth level and future outlooks for European economies are still not where they were in the years prior to 2008. According to the European Central Bank Database, total GDP in 2012 reduced by .9% and .3% in 2013. In 2014 the total GDP was able to become positive, with a total increase of 1.2%, and increasing by 2% in 2015. These improvements were certainly better than the near 5% decrease in GDP in 2008/2009 however, the necessary improvements in financial well being have yet to be seen. (Bank, 2016).

The United States during recent times of financial turmoil turned to an alternative approach in attempting to restabilize and reboot a less than spectacular economy. As explained previously, reducing interest rates is usually one of the first policies enacted in the time of a financial slowdown or economic reduction. Deccreasing interest rates encourages bank lending and consumer spending, which can jolt an economy when needed and produce results that resemble a healthy economy. However, in times with such great economic upheaval, one policy is generally not enough to heal an economy. With United States’ interest rates already approaching zero, the Federal Reserve feared that if they lowered interest rates any farther, the country would be left in a liquidity trap, where conventional economic policies could no longer help them.

It is believed the policy that most helped the United States avoid total financial chaos when they could no longer lower interest rates was the mass purchasing of government bonds and securities. This policy, known as quantitative easing,  allowed for an injection of money into the US economy. In 2015 the ECB began to use quantitative easing in hopes of creating similar outcomes as Japan, the United Kingdom and the US, who were able to yield positive economic results from the asset purchasing program. How QE is performed is relatively simple; a country’s central bank purchases securities such as government bonds using electronic cash that was not in circulation before the purchase. By doing this, a country can theoretically stimulate its economy by injecting money into its balance of payments. In theory, this should encourage banks to loan more money, boost investment and create more economic activity. This policy also is effective because it is able to introduce more money into the economy without having to print more cash, thus, avoiding inflation in the short term. Six years after the United States first launched its own QE program, the ECB,  still unhappy with their slow economic recovery launched their own QE program. In March of 2015, the ECB enacted a 1.1 trillion euro asset purchasing program despite opposition by certain European countries (Randow, 2016). Those who opposed the program claimed it would be dangerous to add such a large amount of Euros to the money supply in a small amount of time due to long term inflationary risks. (Randow, 2016).

Given the success the United States received by nearly quadrupling their balance of payments sheet through their asset purchasing program, the ECB set out on a very detailed plan on how they would be implementing their quantitative easing. The plan was titled the Expanded Asset Purchasing Program (APP), which include four smaller asset purchasing programs within it. Of the four programs included in APP, the largest of the programs is titled the Public Sector Purchase Program (PSPP) and was originally scheduled to last from March of 2015 only until September of 2016, however the ECB maintained that the period of the program will be sustained until there were clear improvements in achieving the desired inflation level over the medium to long term. The program has since been expanded until March of 2017. Some of the general rules outlined in the PSPP were to impose limits on the purchasing of assets to ensure that the ECB would not interfere with the laws outlined by the prohibition on monetary financing (ECB Asset Purchasing Program, 2016). The ECB determined that each month they will purchase 60 billion euros worth of assets, and that 60 billion will be broken up into very specific parts. 10 billion of the euros were to be dedicated to buying covered bonds and asset-backed securities. Six billion would be spent on the purchasing of debt for countries inside the Eurozone and the money spent would only be kept in euros. Finally the remaining 44 billion per month would be spent on sovereign debt securities and for National Central Banks such as El Banco de España (Bank, 2016). There were also limits set on which kind of bonds and assets that the ECB could purchase. The bonds had to reach maturity between 2 and 30 years. In addition, the bonds had to have a 25% issue limit and a 33% issuer limit on eurozone holdings.

Among the other three branches of the APP includes the Corporate Sector Purchase Program, which includes the purchasing of corporate sector bonds. The ECB claims that this part of the program will, “further strengthen the pass-through of the Eurosystem’s asset purchases to financing conditions of the real economy” (Bank, 2016). The Asset-Backed Securities Purchase Program (ABSPP) was created to help banks diversify funding sources. The thought process behind buying these assets was to allow banks to continue lending money to the general public. Purchasing these assets will help create optimal credit and funding conditions. The final branch of the APP is the third installment of the Covered Bond Purchase Program (CBPP3). This part of the program provides credit to the economy, which in turn aims to create positive spillovers to outside markets (Bank, 2016).  

The graph pictured below shows ECB asset purchases since QE was implemented in March of 2015. The Graph shows a steady increase in the number of assets owned by the ECB and is representative of the ECB’s success in purchasing bonds and other asset-backed securities. The number of assets owned by the ECB will continue to grow into the future as the QE program extends into the future.

While it is clear that the ECB has been effective in their asset purchasing program, what still remains not fully clear is the effectiveness of the program. In theory, the asset purchasing program, which injects money into the economy should result in increased overall economic performance in the long term. The ECB and other central banks would not have engaged in these programs unless they believed there would have been significant results to improve the economy and stir up growth. The effects of quantitative easing have been documented in other countries, however, the effects that the program has had on Eurozone countries is not as well documented, due to the recency of the policy implementations.

 

Literature Review:

As of right now, the ECB is not fully satisfied with the results it has received from its quantitative easing program. With the decision to extend the program, into 2016 and beyond, perhaps the ECB thinks the program just needs more time, and is still optimistic about the potential results of the program. However, because there are a finite number of assets for the ECB and other central banks to purchase, if the program were to continue on the path it is, there will need to be adjustments made to the criteria that separates which bonds the ECB can and cannot buy (Claeys, 2016). As of right now, there is concern over whether or not there will be enough assets to buy given the threshold of buyable bonds that the PSPP currently has in place. If the options of buyable debt become scarce, there is an expected schism between top leaders of the ECB and individual sovereign leaders such as Jens Weidmann, the head of Bundesbank. These leaders are aware of the possible drawbacks by adding so much credit to the european balance sheet. Those who do not believe the ECB should continue to purchase assets, namely the Germans, are wary of the potential inflation that can be created (Claeys, 2016). Presumably, when the economies begin to grow and expand  the excess reserves and assets purchased during QE linger, creating inflation. Typically, Germans tend to be more inflation averse than other countries given their economic history, however, they are far from being the only ones who see potential inflation resulting from QE as a large problem down the road. The research conducted by the International Monetary Fund, in their 2016 World Economic Outlook, projects the inflation level in years 2017-2020 to approach the target rate of 2%. While these estimates anticipate a more steady inflation rate in the near future, there still is some amount of uncertainty given the volatility of the markets. Economists also worry about the long term inflation level, while the projections made by the IMF mostly deal with the near to mid future.

Jerry Tempelman, author of an editorial article in the Financial Analysts Journal, claims that the QE programs being implemented by the ECB may have worked in the US, however, they will face much larger challenges in the eurozone. Tempelman also argues that there is a potential inflation problem when financial markets recover and economies become more normalized. He argues there will be an eventual inflation problem due to the excess number of reserves existing in the economy (Tempelman, 2012). However, he argues that unlike the Federal Reserve, the ECB does not have the tools needed to unload the excess credit and avoid a problem with inflation. The author argues there is a key difference between the quality of assets being bought by the Federal Reserve and the the ECB. While the United States has bought assets that have received low risk ratings, the ECB has failed to do so (Tempelman, 2012). Tempelman points out that the ECB has not bought assets from the generally risk free European countries such as Germany and Netherlands, choosing to buy assets from countries that credit carries much more risk, such as Italy and Spain. By purchasing assets from countries that carry more risk, Tempelman points out that the ECB is essentially passing on risk from those participating in the capital market to all Eurozone taxpayers (Tempelman, 2012). While these arguments are based in theory and economic intuition, it is still too early to tell if these hypotheses can be proven correct or incorrect. However, it is still important to realize these are real problems that economists and policymakers are considering when they face tough decisions, such as whether to continue QE in Europe.

Tempelman is not the only economist who believes that quantitative easing policies are best suited to work in the United States, and perhaps not a great fit for the ECB. Martin Feldstein, Professor of Economics at Harvard University explains that one of the main goals of the QE program in Europe was to stimulate consumer spending. Felstein notes that Europe does not have the same widespread share ownership that is present in the United States, because of this, QE policies are not as effective in raising household wealth, thus inducing spending (Feldstein, 2016). Another supposed effect of the quantitative easing policies is inflation moving towards the target rate. Feldstein argues that this is unlikely to occur because of how high the unemployment level is. At a massive rate of 12%, five whole points higher than it was before the financial crisis, the policies are unlikely to affect inflation unless unemployment comes down. (Feldstein, 2016). The author argues that the only way the ECB will be able to achieve its target inflation rate is to increase their import prices, leading to a reduction in the value of the euro. However, even then, Feldstein does not see the core inflation rate being higher than 1%. Feldstein remains one of the more critical economists regarding quantitative easing in Europe, however, he has yet to be proven wrong on this issue. With the lack of data surrounding the topic, for the most part, all people can do is make educated guesses about the future.

While many studies have looked at how successful (or not) European QE policies have been in achieving their intended results, one author has chosen to look at an unintended consequence of quantitative easing. The Financial Times reports that through the large scale purchasing of assets, there has been a, “squeeze on the availability of assets favored for trillions of euros of repurchase agreements, or ‘repos’ – effectively short-term loans between institutions” (Moore, 2016). It has also been reported that this has created market dysfunction, which is creating serious problems. The importance of the repo market is highlighted in its usage by banks and other financial institutions to raise short-term loans that are backed by collateral. The repo market was largely ignored before the financial crisis, but has since become very important due to its ability to make financial markets safer and carry less risk. At the cost of driving down long term bond yields, the functioning of the market has been impaired (Moore, 2016). Given the newfound scarcity for collateral, markets have become riskier, which is something all parts of the world do not want to see.

 

Methods and Results:

The first step in empirically analyzing the effectiveness of quantitative easing will look at measures of overall good economic health. The measurements used to quantify overall economic health are: gross domestic product (GDP) measured in billions of United States dollars as a percentage change from the previous year, investment measured as a percentage change of GDP from the previous year, gross national savings (GNS) as a percentage change of GDP from the previous year, and finally, net government debt, also measured as a percentage change of GDP from the previous year. These four measures were thought to best represent the overall health of the economy, and in theory, should have improved across the board as a result of the ECB’s QE programs. The dependent variable used to represent the QE program is a measurement of securities held by Eurozone countries as a percentage change from the previous year. This measure was used because the ECB does not specify in their public data exactly which of their added assets are directly from their QE programs. There is also not a QE measurement specified by the ECB. The variables were measured in percentage change from the previous year in order to best capture the effectiveness of quantitative easing in the short run. The increasing measure of securities held should be able to properly represent QE because the securities held by countries increases significantly after QE is implemented. An issue with using these measurements of overall economic health is that they are generally slow to turnaround. It is very unlikely for one policy to drastically shift all of these measurements in an upward direction, especially following such a broad sweeping global financial crisis. The IMF was able to predict some measurements at future values in the years 2017, 2018, 2019 and 2020. While these estimates were carefully predicted by financial experts, it still should be noted that they are not actual reported values. It took the U.S six years to get results satisfactory enough to suspend their QE programs and it is important to note that the ECB’s policies are still in their early stages and more time is needed to make a full and empirically grounded assessment of the program. That being said, the tests were still run in order to give a check in.

Source: SS df MS
Model 59964.05 4 14991.01
Residual 13.399 1 13.3999
Total 59977.45 5 11995.5

 

Number of obs f(4,1) Prob > f R-Squared Adj R-Squared Root MSE
6 1118.77 .0224 .9998 .9989 3.6605

 

Securities Held coef: Std Error t P>t 95% conf upper interval 95% confidence lower interval
GDP 162.2282 3.29 49.22 .013 120.34 204.11
Investment -65.5262 1.486 -44.09 .014 -84.41 -46.64
GNS 44.847 1.763 25.42 .025 22.43 67.26
Gov Debt -1.642 .6799 -2.42 .25 -10.282 6.996
Cons. -211.56 5.951 -35.55 .018 -287.1776 -135.9471

 

Surprisingly, the data used in this analysis was able to explain the variation extremely well. With an R-squared value of .9998, the variation in the response data almost completely fits around the mean. In other words, the percentage change in securities held by the ECB was able to explain almost all of the variation in the other variables that were tested in this analysis. As these measures of overall economic well being take a long time to change in response to one specific policy, this was not expected. Given the results, we are to conclude that the changes in the overall economic well being variables can be explained by the changes in the asset purchasing variable.

A measurement that does not take as much time to come around is the level of inflation. This measurement was chosen because the ECB leaders specifically said they will continue to use QE programs until they reach their target inflation of 2% for the medium to long term. Inflation is also a measurement that does not take as long to see the effects in, following policy implementations. The money created as a result of QE does not involve the printing of cash, so the changes in inflation are simply measures of economic health. The ECB wanted to see direct results in inflation due to the implementation of their QE policies, so a regression was run using the percentage change in the purchasing of assets from the previous year by the ECB as the dependent variable and change in inflation levels from the previous year as the independent variable. Although inflation levels are not as slow to move as the previous measures used above, there still is some lag. Therefore, the IMF predicted values of inflation from 2017-2020 were used in this evaluation. Inflation levels approaching 2% for the medium term would signify the effectiveness of the QE policies.

 

Source: SS df MS
Model 11861.2853 1 11861.2853
Residual 125622.887 6 20937.1478
Total 137484.172    7 19640.596

 

Number of obs f(4,1) Prob > f R-Squared Adj R-Squared Root MSE
8 .57 .4801 .0863 -.0660 144.7

 

Securities Held coef: Std Error t P>t 95% conf upper interval 95% confidence lower interval
Inflation 38.1866 50.73456 0.75 .480 -85.95639   162.3296
Constant 60.07343 82.61053 .73 .494 -142.0673 262.2141

 

Given the results, we are to conclude that the change in assets purchased variable does not do a good job to explain the variation in the inflation variable. In fact, we can conclude that almost none of the changes in the inflation variable can be explained by the change in the number of assets purchased. This is surprising, given the fact that in the past few years, the inflation level has risen closer to the target rate of 2%. This would suggest that there is another factor leading to the healthier inflation level in the Eurozone. This was also an unexpected result due to the likelihood of inflation to change in the medium term.  

A third measurement was used in order to examine the effectiveness of QE in the Eurozone. Due to the short amount of time QE policies have had to show their effectiveness, it is difficult to give a fair assessment of the program because so many of the measures that quantify if the program has been successful or not take time to show. To make up for this, the change in yields from the previous year for two year and 10 year bonds were examined. These measurements are used to quantify the effectiveness of QE because they take little time to change. The bond market is ever changing and so the effectiveness in government programs can be seen quickly by looking at the change in yields. During the financial crisis, yields were relatively high due to investor speculation that a government might not be able to pay back those loans. The effectiveness in QE would be shown through the reduction of bond yields because it would signify investor confidence that the eurozone economies are rebounding and safer bets to payback their loans. Like the other regressions, percentage change in assets purchased was used as the dependent variable while the measurements of two year and ten years bonds are used as the independent variables.

Source: SS df MS
Model 31616.5649 2 15808.2825
Residual 105867.607 5 21173.5214
Total 137484.172 7 19640.596

 

Number of obs f(4,1) Prob > f R-Squared Adj R-Squared Root MSE
8 .75 0.5203 0.2300 -0.0780 145.51

 

Securities Held coef: Std Error t P>t 95% conf upper interval 95% confidence lower interval
2 Year Bond Yields -.1712704 .7639943 -0.22 0.831  -2.13518 1.792639
10 Year Bond Yields 3.579628 3.124493 1.15 0.304 -4.452136 11.61139
Constant 154.806 64.23187 2.41   0.061 -10.30722 319.9193

 

Based off of these regressions, we are to conclude that the variation in ten and two year treasury bond yields is weakly explained by the variation in the securities held variable. This is also a bit surprising. Typically, treasury bond yields are rapidly changing, which is why they are good measurements for the short term. The data does suggest that treasury bond yields in the Eurozone have been decreasing, signifying that the economy is on the rebound. It is just surprising to see that the number of assets held by the ECB has weakly affected the changes in these treasury bonds. While there have been signs of economic turnaround in Europe, the data collected from this paper suggests that the changing number of assets held by the ECB has had little impact other than in the previously stated long term measurements of economic health.

 

Conclusion:

During times of financial turmoil, the ability to use innovative policy is key. Due to the ineffectiveness of traditional economic manipulation, central banks and governments around the world turned to quantitative easing. While the effectiveness of asset purchasing programs were not as well studied when countries such as the United States implemented them, the courage to take risks was key. With more information and data coming out every month on the effectiveness of QE policies, Europe turned to this policy in 2015. In the hopes of rebounding a slow to recover economy, the ECB took a risk by implementing these policies. They saw the work that the policies had done in other countries such as the UK, Japan and US and decided to give it a shot. While the effects of the policy in Europe is not as well studied, the fact that the ECB decided to implement this program speaks volumes about the success achieving in other countries through asset purchasing. While not enough time has passed in order to make a complete and fair assessment, the results gathered in this paper suggest that perhaps asset purchasing programs are not destined to work in the Eurozone. Other financial analysts and economists have voiced their concern the ability for asset purchasing programs to work in Europe. With the first round of ECB QE in the books, and another round on the way, in this point in time it appears skeptics have been right. While hope remains that QE policies can be effective, it appears that only time will tell.

 

Bibliography:

Bank, European Central. “Asset Purchase Programmes.” European Central Bank. ECB, 2016. Web.

Bank, European Central. “ECB Statistical Data Warehouse.” ECB Statistical Data Warehouse. ECB, 2016. Web.

Bank, European Central. “The Financial Crisis and the Response of the ECB.” European Central Bank. ECB, 2009 Web.

Claeys, Gregory. “The European Central Bank’s Quantitative Easing Programme: Limits and Risks | Bruegel.” Bruegel. Bruegel Publications, 15 Feb. 2016. Web.

Feldstein, Martin. “The Shortcomings of Quantitative Easing in Europe.” Project Syndicate. Project Syndicate, 29 Jan. 2016. Web.

Moore, Malcolm. “ECB’s QE Programme Strains Eurozone Repo Market.” Financial Times. Financial Times, 17 Oct. 2016. Web.

Randow, Juna. “Europe’s QE Quandary.” Bloomberg.com. Bloomberg, 8 Dec. 2016. Web.

Tempelman, Jerry H. “Against Quantitative Easing by the European Central Bank.” Financial Analysts Journal 68.4 (2012): 4-6. Web.

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