Quantitative easing defined and the ECB

by George Hatjoullis

Mario Draghi seems to have left many people confused about what precisely the ECB measures constitute. Was it quantitative easing or not? Indeed many people seem somewhat confused about what quantitative easing entails. Evidently not regular readers of this blog. To revisit might be useful. The central bank normally operates via the commercial banking sector. It encourages banks to lend more, or less, and establishes a base for the cost of credit. This is credit policy. The precise operation depends upon the specific banking system in question but the general principles of credit policy are covered in my economics series of blogs. Essentially it involves commercial banks expanding, or contracting, their balance sheets.

Unfortunately credit policy is elastic and quite often does not achieve the desired effect. At the moment, commercial banks are reluctant to expand their balance sheets despite some serious encouragement from the central banks and especially the ECB. Enter quantitative easing (QE). The central bank can always expand its own balance sheet by directly purchasing financial assets in the open market. This in its simplest form is QE. The impact, however, is less obvious than with credit policy. To illustrate, let us assume that the CB only buys assets that are uniquely held by commercial banks (no such assets exist, this is just for illustration). QE then removes assets from the balance sheet of the commercial banking sector and replaces them with cash in accounts with the central bank. If the commercial banks are happy to hold more cash with the CB then nothing very much happens. However, presumably they are not happy as they would not have held the assets in the first place (unless of course they are non-performing and they could not sell them, but then the CB would not buy). The loss of assets will motivate commercial banks to restore their balance sheet which, of course, means expand credit. In this sense QE could be viewed as a variant on credit policy.

Now let us assume QE involves the CB buying assets only held by the non-bank sector (again a hypothetical example). The CB places cash in the hands of the general population where assets were once held. The general population it is assumed will not simply hold the cash and will either purchase other assets or spend the cash. They may buy property, new furniture, equities, new cars and so on. The net effect of this QE process is to create a wealth effect. The purchase of the assets by the CB raises assets values both directly and indirectly. If the purchases are sufficiently aggressive then the process of boosting asset values will boost net spending. It is a wealth effect.

In practice the assets purchased by the CB are held by both banks and nonbanks. The illustration is just to emphasise that QE operates through credit and wealth channels. In an environment in which banks are actively seeking to contract their balance sheet the credit channel will be less effective. The banks will be happy to sell assets to the CB and hold cash. The effectiveness of QE is then left largely to the wealth effect. The boost to property prices in the last 6 years is thus hardly surprising though the extent has been quite exceptional. QE has made those with assets richer and made it cheaper finance asset holdings. The effects are evident in the UK and the USA and, more recently, Japan. The ineffectiveness of credit policy is very evident from the condition of the eurozone (though synchronous austerity is also implicated).

QE is normally conducted through CB purchases of government debt. This has the effect of depressing yields, which automatically raises asset values, other things being equal. Government debt is widely held by both banks and nonbanks. The ECB seems to be focusing on purchasing Asset Backed Securities (ABS). These are packages of loans (car, personal etc) normally found on bank balance sheets. Although, strictly speaking, QE, because the ABS will sit on the CB balance sheet, the net effect is via banks and thus de facto credit policy. The ECB’s move to QE is in name only.