21 January 2015

Why Eurozone QE could mean Grexit


Most commentators expect the European Central Bank (ECB) to announce quantitative easing (QE) for the Eurozone later this week. French President Francois Hollande is so confident that it’s going to happen that he even pre-announced it to French business leaders.

But it’s actually very difficult to see how QE could be implemented at present without driving Greece out of the Eurozone.  Here’s why.

The main QE programmes in the UK and US involved the central bank printing new money to buy national government bonds.  Such bond-buying involves potential losses — e.g. if the bonds fall in value.  So to avoid the risk that leads to the central bank going bust (an event which could ruin your whole day) Her Majesty’s Treasury has indemnified the Bank of England against QE losses — i.e. said that if the Bank loses money on QE bonds the Treasury will make up the difference.

In the Eurozone, national governments own the ECB collectively.  But if QE is simply done collectively — e.g. if the ECB buys even amounts of government bonds across all Eurozone Member States and the only guarantees against losses are the collective ownership of the ECB — then if bond prices fall in one part of the Eurozone that involves losses to the governments of other Eurozone members.  QE would then become a means of pooling debts across the Eurozone, with the Germans and Dutch paying and the Greeks and Italians gaining.

Avoiding such debt pooling has been a central concern of the Germans ever since the Eurozone crisis began — the German constitutional court even ruled the previous ECB wheeze, the so-called “Draghi Plan” for buying Italian and Spanish bonds, illegal.  So it should be no surprise that reports suggest those planning Eurozone QE are intending that Member State governments indemnify (i.e. guarantee) those QE purchases that are of their own debt.  That way, any losses are borne by the national Treasuries and there is less risk of debt pooling.

But next weekend, just three days after the ECB meets to start QE, it seems very likely that Greece will vote for a SYRIZA-led government that is committed to securing a write-down of Greek government bonds — i.e. not paying them back.  SYRIZA is hardly going to agree to guarantee to make good on losses on bonds it says it intends to default upon!

That means it’s very hard to see how Greece could be included in Eurozone QE.  But, conversely, if there were to be Eurozone QE and Greece were to be excluded, in what sense would Greece really still be in the Eurozone?  The ECB’s flagship policy of injecting additional money into the economy to combat deflation would simply not apply in Greece!  No ECB monetary policy for Greeks!

SYRIZA says it believes QE should be done another way — e.g. by the most money being injected into those Member States where deflation is highest.  But that kind of proposal fails to grasp how the ECB thinks.  The main problem with Greek deflation, as far the ECB is concerned, is that there hasn’t been enough of it!  Greek deflation is a key means of “internal devaluation” to restore Greek competitiveness within the Eurozone.

If QE proceeds elsewhere but not in Greece, we should expect the wedge between yields on Greek sovereign debt and yields on other Eurozone sovereign debt to rise rapidly, inducing losses on holders of Greek debt such as banks.

So, even before the question of whether Greece might be ejected from the euro because of SYRIZA’s insistence upon not paying back loans from its Eurozone partners, or Greece choosing to leave the euro because of the refusal of others to negotiate, the most immediate issue is whether Greece can be included in QE and, if not, in what sense will Greece still be in the euro if it is not included in the main ECB monetary policy?  “One size fits all…except the Greeks.”

Dr. Andrew Lilico is an economist and Executive Director of Europe Economics.