What if quantitative easing never ends? The European Central Bank is likely to announce a new asset purchase programme on January 22. Investors are excited, and eurozone government bonds are trading at record-low yields. But the markets’ euphoria is misplaced: QE is the ECB’s most powerful weapon, but it cannot save Europe on its own.
Without government support on fiscal stimulus and reforms, QE may end up only boosting financial asset prices, or even creating a self-defeating trap. QE has worked well in the US, by lowering refinancing costs for firms, boosting confidence and spending, and keeping the dollar cheap.
But Europe’s financial system structure is different and only one of these transmission channels will work. Lower government bond yields will not benefit Europe’s smaller companies, which create more than 80 per cent of new jobs. While such firms can borrow via capital markets in the US, in Europe they rely mostly on banks for credit. European banks, though, are still weak; 10 per cent failed the ECB stress test in October and another 24 per cent passed by a narrow margin.
This suggests about a third of banks are not in good shape to restart lending. As for the wealth effect, QE works. The problem is it benefits the wealthiest households that hold most financial assets, but are also less willing to spend the marginal gains. An ECB working paper from March 2014 estimates the top 10 per cent of the population is three times less likely to spend following a gain in wealth than the bottom 50 per cent. After six years of rising unemployment and declining wages, it is unlikely that QE will push Europeans to go on a spending spree.
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