As Greece voted to install left-wing and anti-austerity party Syriza last weekend, the European Central Bank (ECB) embraced quantitative easing as a measure to stabilize the eurozone. While quantitative easing tends to lift the prices of assets such as stocks and real estate, it should have the opposite effect on the relative value of the euro.
Details of ECB Quantitative Easing
When an economy becomes weak, a modern solution to faltering growth is printing money and buying bonds, a process otherwise known as quantitative easing (QE). By expanding the central bank's balance sheet as opposed to printing new money outright, QE is theorized to be more effective in stimulating real growth.
The problem has been that despite weakness in the European economy, the European Union’s founding documents prohibit the ECB from financing governments. Large-scale government bond buying might violate those rules. In 2012, ECB President Mario Draghi had pledged to do “whatever it takes“ to save the common currency from collapse. Now, as Greece threatens to leave the euro, it seems that QE is what it takes.
On January 22, Mario Draghi announced a sweeping round of QE aimed at sparking demand and economic growth in Europe. The ECB will buy €60 billion of government bonds per month through at least September 2016 in a €1.1 trillion QE package. The hope is that the extra money pumped into the eurozone economies through the bond monetization program will stimulate demand, stave off deflation, and bouy shaky European stock markets. (For more, see: Quantitative Easing: Does it Work?)
Effects and Consequences of ECB QE
One immediate effect of a QE announcement is a rise in asset prices, including stocks. The extra money put into the economy is intended to flow to asset purchases and increase investment. Investors tend to bid up asset prices in anticipation of that economic flow. At the same time, the value of the euro relative to other world currencies will fall. In fact, the euro is now trading at nearly record lows vs the U.S. dollar, exchanging at $1.13 on January 30.
QE will also ensure that already low interest rates in Europe will remain low, with the possibility that real interest rates may even turn negative. While low rates benefit borrowers, it can negatively impact lenders such as banks and those with defined future liabilities, such as pensions and insurance companies. A major concern is that low rates can inflate asset prices too much, leading to bubbles that eventually pop with disastrous consequences. The risk of creating asset bubbles increases uncertainty, which may actually counteract the intended effect of increasing investment.
QE also tends to increase wealth inequality, as it benefits the relatively rich already in possession of stocks, real estate, and other assets. Households in the eurozone typically have a lower allocation of equities than their American counterparts who largely own stocks via retirement accounts. Any potential boost to stock prices from the ECB’s QE is likely to have smaller wealth and confidence effects than QE had in the US.
The Bottom Line
Quantitative easing can work to stabilize economic activity and boost growth. A six-year QE program helped the United States emerge from the Great Recession. However, QE also carries a number of risks and consequences that can lead to negative outcomes. In announcing a €1.1 trillion QE package, the European Central Bank believes the rewards will outweigh the risks. Namely, the ECB hopes QE can keep the eurozone economy strong—even with a Greek exit—and prevent the region from entering another recession.