“I will do whatever it takes”, these words resonate in the financial markets and, with the return of deflation, makes Quantitative Easing (QE) unavoidable. Will it work? That is the question that dominated the press and commentators on the Friday following the historic ECB press conference. Reading these comments, I miss two arguments that to my opinion will play an increasingly important role in the coming months.

There are four traditional mechanisms through which QE may work. It can take effect by reducing interest rates, especially long term interest rates that are important for investors. That will not work because they are already low. It may reduce the interest rates for distressed governments a bit, but this has only limited power to stimulate the economy as a whole. Another mechanism is (according to the credit view) by improving the balance sheet of banks – direct or indirect by reducing company losses –  and thus improving the conditions for lending. Do not know, but I guess this will also not work, because balance sheet conditions are not the crucial thing at the moment why banks in the Euro area are not making loans. The third mechanism is by avoiding deflation itself. If prices fall then this increases real wages and real private debt, which both are likely to reduce economic activity. As a defensive strategy, my guess is that this will work, given the size of the package and by credibly shifting inflationary expectations and putting a floor on asset prices. But it will not raise the price level, so we cannot expect a return to growth through this mechanism.

The fourth mechanism deserves more careful exploration. The effect of QE has been pronounced in the currency markets. The Euro has fallen substantially, and the only way in which it may appreciate, according to the Dornbush overshooting model, is when a rise in inflation will cause real interest rates to go up by tightening credit conditions, which to me is unlikely to happen even in the medium run. The substantial real fall in the Euro is then indeed likely to boost competitiveness of the Euro area. The timing also seems perfect. Low oil prices keep inflationary pressures of depreciation low. In addition, the Fed is ending its period of QE, so there is limited room to counter a monetary expansion of the ECB.  Potentially, such beggar-thy-neighbor policies can go terribly wrong, but for now the ECB seems rather safe in its timing. Whether the Fed is going to forget easily the lack of support of the last two years and then the sudden ECB move to steal the fruits, have no clue.

This leaves us with two more subtle issues, unexplored. The first one is the risk pooling of the bond purchase programme. On the face of it, there is very limited risk sharing, which is seen so far as a concession to Germany and the Netherlands. Sharing will only be of EU institutional debt (which is already shared by the member states) and crucially the European Stability Mechanism debt, although that is not clear. ESM debt is especially tricky, since it actually boils down monetising at the EU level the effects of the banking crisis. Asked about the limited formal element of risk sharing (20 percent), Draghi called this discussion ‘futile’. Had to think hard about this, but I guess he is right. The system of National Central Banks (NCBs) is so interconnected that there is de facto risk sharing, even if the Thursday agreement itself breaks with solidarity among central banks. This then also implies that the ECB received the queen of spades that it was trying to avoid all along: the forced federalisation of fiscal policies through the interconnectedness of the central banking system. This will have substantial political consequences.

In the coming months, the Northern member states will wake up to the reality that the Stability and Growth Pact has become a hardball game. So far, the enforcement of the SGP had the etheric goal of looking after the ‘stability of the Euro’. But now, there is the option of indirect fiscal transfer through the system of Central Banks. My feeling is that this will force a much tougher stance by the Northern states, just at the time that Renzi (and Hollande…) will want to renegotiate the binding ties of the SGP. So, we have to anticipate a substantial deepening of the divisions when the European Commission is going to report on the progress of debt reduction and reform in spring. This stand-off is likely to make the discussion on the necessary moves towards a deeper political union even more difficult. It will raise the stakes and will create more fundamental uncertainty about the long run viability of the European project.

The second unexplored issue concerns the lack of scientific evidence on the effects of QE, we economists really do not know much about the contextual setting under which QE will work. What is often forgotten by the public at large is that in the US the QE programme more or less fall together with a move towards Forward Guidance (FG). FG means that the Central Bank commits that when the Taylor loss function outcome (high inflation, high unemployment) is above a certain threshold, that expansive monetary policies are not reversed. Although as said there is no proof, my feeling is that much of the effectiveness of QE rests on the complementarity of forward guidance. Without such guidance, QE of the ECB is quite likely to create substantial uncertainty in markets. Not only towards the end (say September 2016), but by backward induction much earlier through anticipation effects.

There are two reasons why, in contrast to the Fed, the ECB cannot use forward guidance to anchor QE expectations. First, its mandate will only allows it to express guidance in terms of inflation. If I look at economic conditions, it would be no real surprise to me if we return to positive inflation quite quickly, so the deflationary basis for QE will then also be eroded quite quickly, justifying calls to end it. But clearly, QE has its true merits in the real economy (the unemployment component), but this will fall outside the mandate of the ECB to include it in FG formally. So, using forward guidance would guide to a very short programme of QE and that is not a risk of confusion that the ECB is willing to take. Second, the economic conditions in the member states are too diverse to focus on Euro area wide forward guidance, it simple makes no economic sense. Actually, the differences in speed are at the core of the problems in the Eurozone in the first place. To be on the fundamentalist moneterist approach side, one may argue that overall deflation masks positive inflation in the North and deflation in the South, which under fixed exchange rates is especially what we would expect as the new equilibrium mechanism for the Euro area. We cannot have both differences in inflation across the Euro area as an equilibrium process as well as positive overall inflation without accepting really high inflation in the North.

The effectiveness of QE will be decided on these last two issues. Will fiscal centralization break the political solidarity? And will lack of forward guidance make QE untrackable? Some agenda for the ECB.

Hein Roelfsema