Will QE Work in Europe?

After years of assurances and promises, Mario Draghi, the president of the European Central Bank (ECB) announced the passage of the European Community's version of quantitative easing (QE). The plan is an open-ended pledge of about 1 trillion euros to purchase both public and private bonds at about 60 billion euros per month until September 2016. Sovereign debt will require additional risk-sharing arrangements. Despite it's wide anticipation, markets from Europe and beyond cheered the move. Now that the monetary pledge has come to fruition, will it have the benefits the ECB and Mario Draghi hoped for?

Why Does Europe Need QE?

Europe needs QE for two simple reasons: to ward off impending deflation and to increase liquidity. The biggest danger the European economy currently faces are falling prices. The dangers of deflation have been well documented on this blog. Lower prices often beget lower prices which can then be disruptive to financial markets (ex: financial institutions rely on the value of underlying assets or inventory remaining stable or increasing).

Reasons It Could Work

Christine Lagarde, the president of the International Monetary Fund (IMF) has claimed that QE is already working. As she points out, the move lower in the exchange rate of the Euro proves that just the anticipation of QE has assisted the European community and its economy. The weaker euro allows European companies to be more competitive in the global marketplace. Additionally, any increase in inflation in Europe will help those economies associated with the Euro.

America as a Proxy

European bankers need only look across the Atlantic for a recent real life example of the effects of QE. The Fed initiated its version of QE in the fall of 2008. The Fed maintained its asset-purchasing program in some form over the following six years. The evidence is far from concrete but the program has been credited for keeping the American economy from slipping in to full blown depression. The main catalyst for implementing the unorthodox policy being the failure of Lehman Brothers. It is debatable whether the US would have suffered a more severe downturn in the absence of QE but most analysts concede that the program was helpful. The context under which both programs were implemented is different. The US economy was not trying to stave off deflation while that seems to be the European Union's biggest fear. Under American QE, asset prices increased creating a intended wealth effect, that helped encourage consumer spending and business capital expenditures. Despite the amount of stimulus the real economy in the US is struggling with low growth but is still the healthiest economy in a weak global environment.

Why It May Not Work

The European version of QE is more complex than its American counterpart. The European Union is comprised of 28 sovereign nations, each with its own banking system, whereas the US only had one central bank to work with. 28 different countries means 28 different political interests and clearly things get more complex from there. Figuring out how much sovereign debt to purchase from each country is a complex undertaking. Will each country benefit equally? Will each country feel the program has been handled equitably? The answers to these questions most certainly will be 'No'. How can Greece and Germany be treated equally? Adding to the complexity are the changing governments in each sovereign nation. It will be a struggle to keep up with the dynamic political terrain throughout the as of now 18-month program.

What if Consumers and Corporations Just Refuse to Spend and Borrow?

What no one seems to be addressing is the elephant in the room: What happens if Europeans are just different consumers and businessmen than Americans? Can QE really have a similar effect on different cultures? Europeans borrow and spend differently than Americans. Their mortgages are different and their housing is different. Adjustable rate mortgages are widely used and do not require being refinanced as often. Europeans aren't used to buying new cars every five years. Auto loan incentives may not induce buyers overseas like they do stateside. The corporate and business culture is different as well. European companies are restricted in their ability to fire their workers. High rates of unemployment, particularly among youth, is not unusual, so affecting employment will be muted. In the US, 10% unemployment was considered lofty, and getting it down to historical averages meant getting people back to work who could then become active consumers again. In Europe, it is harder to create more consumers from the ranks of the unemployed.

Boom or Doom?

The immediate fear in Europe regarding its QE program is that bond prices are so high the government will be buying bonds at elevated levels, not giving itself any cushion in the event of a down draft in prices. With rates at historic low levels, and in some cases negative, the ECB may not help but lose money on its purchases. The easy answer to this concern is the ECB can sit on the bonds until maturity.
Many of the concerns that will be analyzed and dissected over the next 18 months are moot. The ECB had to implement some strategy to fend off deflation and get the European Union and its economy back to growth. A weaker Euro should assist in that endeavor. Rates cannot realistically go any lower but the extra liquidity should find its way in to the economy in some form or another. Asset prices should rise and this in itself is a form of inflation and can lead to additional spending by consumers and businesses which ideally will lead to some inflation and hopefully economic growth. In the meantime, it's good theatre for the Americans.