It may help to think about the difference between physical cash (coins & banknotes in circulation) and money as represented by the balance of a bank account. Both are money because an individual can go to an ATM and empty their bank account of money by withdrawing it in the form of banknotes. Simplifying matters a little, what the ECB has done today is to allow 523 banks to deposit €489 bln of sovereign bonds (collateral) with the ECB and in turn to electronically credit the accounts of those 523 banks with €489 bln of money (a secured loan which the ECB wants repaid in 3 years time, with interest please). NB. The ECB has thus grown its balance sheet. It is true that the ECB also controls the amount of banknotes in circulation (it sends them to a bank when the bank requests them – and, just like an ATM, it reduces the bank’s electronic balance by the amount they have just physically withdrawn).
What the Fed does in its version of QE is to buy government bonds from banks and pay for them by electronically crediting the accounts of the banks. But the difference is this is not a loan and the Fed does not require the bank to pay back the money at a specified date in the future – the Fed now owns the Treasuries outright. NB. The Fed thus grows its balance sheet too.
This is where we get into semantics because both central banks have done the same thing in different ways – they have both grown their balance sheets by adding government bonds to one side of their balance sheet whilst crediting banks’ current accounts on the other side of their balance sheet. Personally I think this is the ECB’s version of QE which is why I have referred to it as the ECB’s “Superwaffe” in the above blog post. In Draghi’s interview with the FT (see link in point 5. above) he is asked directly whether this is Europe’s version of QE and he replies that “each central bank has its own rules and vocabulary…we call them non-standard measures”.

As to your question about inflation, one way of thinking about it is to say that inflation is defined as “an increase in the money supply”. Some people then go on to add “which leads to more money chasing a finite supply of goods & services which leads to an increase in their price (which shows up in the inflation rate, as measured by an index which has been created by the government)”. Crucially the circumstances in which QE or Superwaffe will lead to inflation require that the money which has been electronically deposited in banks’ current accounts at the Fed/ECB needs to find its way into the real economy – so people can then spend it on (a finite supply) of goods & services.
If it just stays on deposit at the Fed then it won’t enter the real economy and it won’t create inflation and this is precisely what we have seen in the States where the Fed has conducted $2.3 trillion of QE and banks’ deposits at the Fed are currently $1.6 trillion. Inflation works in the same way in all currencies whether they are US Dollars, Euros or Reichmarks – if the money supply in the real economy grows too quickly then the result is inflation. Just play “follow the money” (always an illuminating process) and see where it ends up.

Sorry for the lengthly reply. I recommend starting by looking at the ECB’s balance sheet as it is much more clearly presented than the Fed’s. LTROs show up in item 5.2 on the LHS and Banknotes in circulation are item 1 on the RHS.

Regards Antonne.

1) Sorry for the naive question, but where does the ECB have this unlimited amount of money to lend? Isn’t that practically equivalent to quantive easing?

2) Can you please explain to us non-finance guys, under which circumstances do quantitive easing lead to inflation? Why it did not (yet?) cause inflation in case of US? Does it have to do something with the reserve currency status of the USD? Would that apply to Euro as well (in case of QE or similar techniques)?

Thanks!
Gergely

To respond to your points in turn:

1. The ECB announced this 3-year LTRO will have “full allotment” so it is unlimited because the ECB will give banks as much 3-year money as they ask for (and can provide collateral against). The link to the ECB announcement is in the first paragraph of my post above.
2. The ECB is happy with this solution precisely because the banks buy the sovereign bonds and the ECB just finances them (albeit for the next 3 years). It is semantics really – the ECB is providing an unprecedented amount of liquidity against a widened range of collateral but it is not actually printing money (importantly the Bundesbank can live with this).
3. Yes this facility does mean taking the debt load to the ECB with collateral equivalent to or less than sovereign bonds. We will discover just how much financing the ECB is providing tomorrow (with more to follow in Feb 2012). If the sovereign bonds fall in price then the ECB will demand more collateral from the banks but if the banks corner the market in a particular sovereign bond then its price won’t fall…
4. I don’t agree the ECB is “collectivising” the debt because the ECB is not guaranteeing the sovereign bonds which it will end up financing via these 3-year LTROs. The ECB is simply providing financing for an extremely wide range of collateral (which includes sovereign bonds).
5. In Draghi’s interview with the Financial Times (published 3 days after the above post) he says “one of the things banks may do with the money is buy sovereign bonds” – very plain speaking indeed for a central banker. The interview is published on the ECB’s website here.

Regards Antonne.

again a very interesting and delighting article from you!

My questions:
- Where do you see that this facility will be offered in unlimited amount to the banks?
- Can you please explain why this particular solution is more acceptable to ECB on a large scale? ECB does not buy sovereign bonds directly because it is against its mandate. German government opposing euro-bonds, because it would “collectivize debt”. Doesn’t this facility – if it would be used unlimited size – would mean taking the debt load to ECB (i.e. collectivizing debt) with a collateral equivalent or below the sovereign bonds?

Generally, are you sure that this facility is more than a liquidity measure, and ECB will indeed allow this to be used for large scale refinancing of sovereign debt?

See Part 4 in

http://www.spiegel.de/international/europe/0,1518,802299-4,00.html

To address your points in turn:

1. This is a core principle of the ECB. I think it is important to bear in mind that the Bundesbank will never forget the hyper-inflation of the Weimar period in Germany’s history which was caused by the Reichsbank printing money without limit. This is why Merkel & the ECB are flatly opposed to buying bonds with printed money (so-called quantitative easing). A Treaty change may prompt the ECB to buy bonds more aggressively (in order to transmit its loose monetary policy across the euro-zone) but they would still sterilise their SMP purchases.
2. You are correct in that the ECB is in a stronger position than other sovereign bond holders to get their money back – c.f. the ECB is not taking a 50% haircut on its Greek bonds. But the problem with excluding a country from the EU and/or euro-zone is that the default on that country’s sovereign euro debt will bankrupt many banks in the euro-zone.
3. Regular audits will only ever achieve anything if a negative opinion from the auditor results in the target country being required/forced to tighten its budget. No wriggle-room allowed!
Regards Antonne.

thank you for the response! It explained some further layers of this highly interesting issue.

You mentioned that there are still two issues preventing Euro-bonds:
1. ECB considers it to be out of its mandate
2. ECB has no tax revenue to back up the commitments in case a member country refuses to pay back.

Regarding these issues:

1. Does the ECB having issues because of the principle, or just because they feel that such operations were not mandated by the current Treaties. In case of common political will and Treaty change, would ECB adjust its position?

2. Although their is no common tax revenue collection, ECB would still be in an extremely strong position to get the money back from a reluctant member (in much stronger position than any regular sovereign bond holder is today), e.g.:
- A potential Treaty change (at the same time as the introduction of joint Euro-bond) could have dramatic consequences for a defaulting country, e.g. automatic exclusion of EU and Eurozone
- ECB has a control over the currency of a potentially reluctant member country

And the regular audits – resulting from the 2 stage distribution – would be able to handle solvency issues much earlier in the road and would be able to effectively prevent the realization of dramatic actions above.

Thank you for your comment. There is clearly much thinking being done right across Europe as to how best to lower euro-zone countries’ borrowing costs given that the debt-to-GDP levels summed across the whole of the euro-zone do not look too bad – it is just that sharp discrepancies occur at the granular level when individual countries are considered by themselves. I was aware of proposals such as ‘red/green’ joint Euro-bonds but this is the first time I have seen the variation that you outline. However I cannot really envisage a central bank of the ECB’s pedigree issuing bonds. They do not see it as their job to finance governments and this is why they have been ‘sterilising’ their purchases of euro-zone sovereign debt under their Securities Market Programme (over €200 bln purchased thus far). Also the ECB has no tax revenue to call upon to service the debt it would be issuing in the event any euro-zone country refuses to pay back the ECB in future.

Regards Antonne.

You mentioned that the biggest problem with joint Euro-bonds was the lack of leverage over euro-zone members who do not play by the rules.

Did you also consider variations of the joint Euro-bonds, e.g. a two-stage and risk adjusted yield model? In this scenario ECB could issue the joint Euro-bond, but the member countries can access the money only after passing the audit of their budget by a corresponding EU institution (or by the Troika). In addition to that, member countries would not receive the Euro-bond with the same yield, but according to a formula:

x (yield of the joint eurozone bonds) + r,

where r can be positive or negative representing the risk adjustment for that country (in light of its sovereign debt GDP ratio, deficit etc.). The value of “r” can be based on objective criteria and only “x” would be subject to market fluctuation.

The two stage distribution would allow to have a handle on the member country’s fiscal discipline, and the risk-adjusted yield would be a strong incentive to improve financial positions. It could also cap the rise of borrowing cost for currently AAA-rated Eurozone countries .

Advantages of this model compared to EFSF:
- It could solve some of the issues with EFSF: to have the proper size and finding buyers for the bond.
- It could be easier to reach an agreement on a European treaty change

What is your opinion?