The European Central Bank has been highly active since the financial crisis began in 2007/8. But if initiatives fail to boost growth, quantitative easing will follow.

September 2014

Key points

  • Growth stalls and deflation looms.
  • Banks fail to pass on cheap funding.
  • ECB’s next targeted long-term refinancing operation due in December.
  • If this funding fails to reach the real economy, calls for QE will intensify.

Busy as an ECB

Nobody can accuse the European Central Bank (ECB) of sitting on its hands. Since the financial crisis began it has cut interest rates, raised them, then bought them down again as low as they might have been expected to go. And then cut them further than that. Twice.

Survive and thrive

The bank has bought covered bonds, although not very many. It even, briefly, bought some sovereign bonds under the Securities Markets Programme (SMP). It has drawn lines in the sand with Outright Monetary Transactions (OMTs) and convinced markets that the Euro will survive and even thrive. It has provided cheap funding to hobbled banks, then even cheaper funding, and now even cheaper still. And it  has stated that it could do more, much more, if necessary.

Stalled growth – again

Arguably none of this has worked. The Eurozone recovery (or recoveries, since there have been two since 2008 and a third is now required) has been muted at best. Growth has stalled again and inflation is perilously close to zero – deflation in other words. If success is to be judged by a convincing and sustained return to robust growth and to the 2 per cent inflation target, then the ECB has failed. It would argue it just hasn’t succeeded fully yet. 

New weapon, stuttering start

Against this backdrop, the bank recently unveiled its latest weapon – a targeted long-term refinancing operation (TLTRO). It did not have an auspicious start. Under the rules prescribed by the ECB, cheap funding of up to €400 billion was available to Eurozone banks under the first TLTRO. Yet just €83 billion was applied for. This puts a dent in the bank’s stated ambition to return its balance sheet to the level of early 2012 - about €3 trillion. 

Balance sheet boost

With the ECB starting from a whisker over €2 trillion, there is a long, long way to go and €83 billion looks like chicken feed. More so as banks are simultaneously continuing to steadily repay cheap funding from the previous two LTROs of late 2011 and early 2012, which totalled almost €1 trillion. If the size of the ECB’s balance sheet is the right metric for assessing the amount of stimulus being provided, then it has certainly succeeded in providing a major boost in the past – at least for a while. 

Wait and see

The problem was that European banks didn’t pass on the cheap funding to the “real economy”. Instead they parked it in high-yielding ‘peripheral’ sovereign bonds (now effectively underwritten by the ECB) and enjoyed the carry gains for anywhere between one and three years before repaying the central bank.


The ECB’s balance sheet is now exactly the size it was before those LTROs. Of course, future TLTROs – the next is in December – along with ongoing purchases of asset-backed securities and covered bonds might yet expand it towards €3 trillion. The ECB was keen to point out that banks might have been waiting for the results of its review of the quality of their assets as part of impending stress tests before taking up these TLTROs. Time will tell. 

What about the ‘real economy’?

But perhaps they won’t. And even if they do, the money will still not find its way to the ‘real economy’. Carry opportunities are much less obvious, but they are not entirely absent. More fundamentally, maybe banks don’t want to lend to the 'real economy'? Besides, does the ‘real economy’ even want to borrow?

Financing to the wrong tune

These last two possibilities are, sadly, the more convincing explanations. Banks may have rebuilt capital, but many are still in very poor health. And if households and companies don’t want to borrow, then the ECB is effectively pushing on the proverbial monetary policy string. You can provide as much cheap funding as you like, but if banks don’t lend it on then credit easing will fail. That is what has happened so far and we believe it will continue to be the case.

If households and companies don’t want to borrow, then the ECB is effectively pushing on the proverbial monetary policy string

Stewart Robertson

Senior Economist (UK and Europe)

Banking bypass

The solution would be for the ECB to bypass the banking system altogether by purchasing assets directly from the non-bank private sector. That would enable the freshly-created money to circulate through the economy, doing what money has always done – lifting asset prices, generating beneficial wealth effects and boosting demand. The problem is that this means proper quantitative easing (QE) - something certain parties have a hatred of.

ECB and QE

Why? It allows monetary financing of budget deficits in profligate countries. And it takes risks with inflation. The latter is quite frankly laughable in current circumstances. The first has some validity – when the ECB bought Italian government bonds in 2011, the Italian government responded by backtracking significantly on fiscal tightening and structural reform. The ECB countered by halting such purchases, allowing the bond market to punish Italy in the form of higher yields. Italian premier Silvio Berlusconi resigned later that year.

How to get the balance right?

To some at the ECB, this episode illustrated a basic problem: successive crises were met with ECB help. But this took the pressure off governments to reform and restore fiscal sustainability. The ECB has to try and achieve a balance between encouraging reforms while also providing assistance where necessary.

Germany has a different view on where the balance is to be struck. But surely the terrible experiences of Greece, Spain, Ireland, Portugal and others in recent years shows that the alternative is far worse. Even if reforms and some fiscal pain were necessary, the pain would have been eased massively by a monetary offset in the form of QE.

Some things never change

Today we face a similar  choice. There is a clear danger of low growth, zero growth or, even worse, an ongoing debt deflation depression. As the prospect of this grim reality draws ever closer, the ECB will have to respond through outright QE just as other central banks have done in the US, UK and Japan. Sadly, it looks unlikely to do so much before the middle of next year.


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