Since the global economic crisis of 2008, we have seen strong recessionary pressures throughout the developed world. GDP growth has been stagnant and the labor market has been sluggish. Dealing with similar conditions, it is interesting to see the different approaches taken by the European Central Bank (ECB) and the Federal Reserve to stimulate their respective domestic economies.
Federal Reserve Approach – Quantitative Easing:
In the United States, the Fed has utilized rounds of quantitative easing as their primary vehicle for stimulus. You can read my article explaining what QE is here. Currently, the Fed’s position is that government spending cuts, the government shutdown, and the everlasting debt ceiling debate are restraining economic growth and the continuation of QE is necessary. GDP growth has been relatively stagnant, we are seeing a high U-6 rate, and the lowest labor participation rate since 1978. The situation in the United States, on the employment side, appears to be structural unemployment combined with a high amount of unemployed applicants for a limited amount of job vacancies.
From a GDP standpoint, at best, “QE has moderate effects on economic growth”. This is a quote from Janet Yellen and calls into question the cost/benefits of the Fed’s approach. The idea here is that the Fed’s purchases of Mortgage Backed Securities (MBS) and long term Treasuries reduces the corresponding interest rates, which raises other asset values causing a “wealth effect”. This new wealth generates spending which increases GDP. There are a few fallacies with this approach, such as underlying asset bubbles that it can cause, which question the overall sustainability.
GDP has grown at 2.8% in the most recent quarter ended September 30, 2013, which is a good sign, but much of the growth comes from a one time buildup of inventories from businesses. This can reverse if there isn’t enough demand to consume these inventories. Considering the employment situation mentioned previously, the consumer demand may not be enough to consume this inventory buildup. There is still great uncertainty with the US, due to the never ended debt ceiling debate. Due to all of these factors, I predict a very slow increase in business investments in 2014.
The key to remember with the Fed is that they can control short term interest rates, but will not typically control long term interest rates. The Fed has purchased more than $2 trillion of longer term Treasuries and more than $1.3 trillion of MBS since the crisis began in the hope that they can lower long term interest rates. Longer term Treasuries are typically viewed as a stabilizing influence on portfolios, such as for pension funds, and continuation of this program will likely result in a shortage of these investments.
In summary, the Fed is following a very “debt oriented” approach to stimulating the domestic economy. It remains to be seen, over time, whether this is ultimately effective. Currently, it does not appear to have been fully effective at stimulating GDP growth or helping to improve the labor market. The high federal deficit in the “QE years” is a problem which will have be addressed at some point in the future, after the economic and employment situation improves.
ECB Approach – Credit Easing:
The ECB has taken a somewhat different approach than the Fed, since their underlying situation was different. The Eurozone is a union of sovereign nations where unsustainable fiscal deficits and debt levels of some of the members raised questions about its long term survival (e.g. Greece). The ECB is also not a “lender of last resort” which means it cannot lend funds or make bond purchases to Eurozone members directly.
The ECB attempted to stimulate the Eurozone by easing collateral requirements and lending more money. Traditionally, for a bank to borrow from the ECB, it would have to post collateral that consisted of secure investments. In the case of Greece, the ECB sought to ease their access to this financing. Additionally, the ECB shifted their policy of collateral, by allowing riskier financial instruments to be utilized. This had the effect of encouraging more bank lending.
Additionally, the ECB began purchasing debt to keep borrowing costs down from the less fiscally healthy members. In 2010, it announced it would buy unlimited amounts of Eurozone debt under the SMP (Securities Markets Program). This increased demand for bonds, lowered borrowing costs, and pushed interest rates down. The ECB also offered unlimited dollar 3 year loans to banks in the Eurozone, which was intended to further stimulate growth and market activity. This was referred to as long term refinancing operations (LTROs) which allowed some banks to borrow cheaply, invest in higher yield instruments, and pocket the profit differential. The hope from the ECB was that this program would encourage investment in the riskier bonds of the PIIGS nations (Portugal, Ireland, Italy, Greece, and Spain). This program was only marginally effective at that purpose. A permanent bail out fund was also established to hedge the risk of the weaker economies dragging down the Euro.
There was criticism that the ECB methods up to this point were in violation of the original purpose of the ECB, per the EU treaty. The aforementioned measures had the result of requiring the more economically stable member states to provide financial backing to the less stable members.
As for effectiveness of the ECB approach, when they intervened in the market to purchase PIIGS bonds, yields experienced the largest fall since the inception of the Euro. The secondary market has not experienced a long term turnaround from the ECB approach and the market still is very skeptical about the prospects of the PIIGS countries, meaning the risk assessment was not lowered. The ECB efforts to minimize their own risk while implementing credit easing has resulted in policies that were not fully effective at meeting their stated goals.
Differences of Approach and Analysis:
The main differences between the ECB and Fed policies are clear. The initial response to the crisis was similar, but we witnessed a divergence by 2010. Due to the nature of the Eurozone, the ECB had to play a role of an intermediary in the sovereign bond markets and to stabilize the inter-bank market. The ECB’s policies can be thought of as credit easing as opposed to quantitative easing. The Fed sought to lower the risk-free interest rate, while the ECB has tried to ease the credit access for banks from distressed member states.
The ECB has focused on more supply side measures and have made an effort to address the debt/deficit situation in the member countries by encouraging austerity measures be implemented. The Fed has purchased substantial risk free assets (Treasuries), while the ECB has purchased a much smaller amount of risky assets (sovereign debt, where market was decreasing). Additionally, while the ECB has been lending extensively to member nation banks with no other access to funding, the Fed has lent relatively little money to banks.
I would not characterize either approach as being successful at meeting stated goals. If I were to pick one today, quantitative easing has been marginally effective at meeting certain goals, while credit easing has not. The ECB focus on reducing their risk, while implementing their programs, has led to their relative ineffectiveness at this juncture. However, it remains to be seen whether the Fed or the ECB will ultimately be proven right. It is also possible that both approaches will be deemed ineffective as time progresses.
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