The European Central Bank’s Quantitative Easing program : will it work?: aA literature study

The European Central Bank’s Quantitative

Easing program: Will it work? A literature

study.

Faculty of Economics and Business Bachelor Thesis

Abstract This thesis uses existing literature to investigate whether the European Central Bank (ECB) should have implemented Quantitative Easing (QE) in March 2015 in the hope to achieve growth and economic recovery in the monetary union. Although the results differ across studies on previous implemented quantitative easing outside the monetary union, there is a consensus in the literature that government bond yields decreased significantly due to the purchase of assets and helped to prevent further recession. The programs mainly differ in the transmission channels. Several empirical studies investigate the QE program implemented in 2012 by the ECB in response to the sovereign debt crisis. These studies show that the

program in 2012 also succeeded in reducing the sovereign debt crisis in the Euro area mainly through the signaling channel without endangering its monetary independence. The review of the empirical literature suggests that it is possible to predict that the current program of the European Central Bank will again boost confidence into the economy and therefore will lead to economic growth in the monetary union, resembling previous outcomes.

Reem Allawy 10201866

In the hands of Rutger Teulings July 14, 2015, Amsterdam

Statement of Originality

This document is written by Reem Allawy, who declares to take full responsibility for the contents of this document.

I declare that the text and the work presented in this document is original and that no sources other than those mentioned in the text and its references have been used in creating it.

The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.

Table of contents

1.

2.

2.1 Conventional monetary policy p. 5 2.2 The channels of monetary transmission p. 6 2.3 The problem with conventional monetary policy p. 7

3.

3.1 Challenges of QE p. 8 3.2 QE in practice p. 9 3.2.1 Japan p. 9 3.2.2 United Kingdom p. 9 3.2.3 United States p. 10

4.

5.

6.

1.

Introduction

In response to deflationary pressures, the ECB has hit headlines with its QE program. Starting from March 2015 to September 2016, the ECB will purchase assets composed of sovereign bonds and securities from European institutions and national agencies amounting to €60 billion, under the Expanded Asset Purchase Program EAPP1. These government bond purchases must be accompanied at national level with structural reforms, as well as fiscal policies that support the overall recovery of the economy. Currently there is an ongoing debate about the impact of quantitative easing on the crisis in the Eurozone. It can be quite difficult to coordinate actions of a group of countries with a common monetary policy, especially since the European Monetary Union (EMU) has to defend its monetary independence. There is a lack of research on predicting the outcome of the implemented program. This paper aims to fill this gap.

The main objective of this paper is to predict whether and through which transmission channels, the large asset purchasing will have an expansionary outcome on the economy of the monetary union. One of the principal findings of this paper is that previous implemented programs by the Bank of England (BoE), Bank of Japan (BoJ) and the Federal Reserve (Fed) were all successful at stimulating economic activity2. In the US and UK economic activity was stimulated mainly through the portfolio rebalance channel, whereas in Japan it was stimulated through the signaling channel. The previous implemented QE program by the ECB in 2012 in response to the sovereign debt crisis was also successful in boosting confidence into the economy through the signaling channel without the actual purchase of government bonds (Henning, 2015). The announcement alone was sufficient enough. Critics argue that the ECB endangered its monetary policy by mixing fiscal policy with monetary policy, but at the end of 2014 there was still no threat of inflation. The amount of the current assets being purchased is similar to that of the BoJ and the Fed. Therefore the outcome will most likely resemble that of previous programs.

This thesis follows the following structure; the second part after the introduction contains theoretical background about how conventional monetary policy is conducted by central banks. To evaluate whether a QE policy was successful, it is necessary to understand through which channels it operates. Therefore a section about QE will follow, in which the channels through which QE may operate are laid out. In this section also QE in practice will be discussed and how the several programs have possibly affected the economy. The fourth and fifth sections describe the situation in the Eurozone and how QE has possibly affected the Eurozone up until now. Section 6 concludes.

1

Source: ECB

https://www.ecb.europa.eu/mopo/implement/omt/html/index.en.html

2

2.

Central Banks

The two arms of macroeconomic policy are fiscal policy and monetary policy. The government implements fiscal policy, regarding spending and taxation. Monetary policy refers to the decisions made by central banks about the nation’s financial system. Central banks control the money supply indirectly using a variety of instruments, called conventional monetary policy (Mankiw, 2013). The role of central bank autonomy has changed post-crisis. Before the crisis, central banking was thought to be restricted in just its mandate. Post-crisis, the role of central banks became more important and therefore its decisions much more complex. Their operations were more directed to financial stabilization as well as price stability and employing unconventional tools, such as quantitative easing (Henning, 2015). Before focusing on these unconventional tools, the next subsections will capture an overview of the traditional tools of central banks.

2.1 Conventional Monetary Policy

Money supply is not only determined by central banks, but also by the behavior of households and banks. The essence of monetary policy is the influence of central banks on the money supply, the banking system and in turn on households. Central banks conduct monetary policy by targeting or controlling the short-term interest rate. This rate is called the Overnight Interbank Interest Rate. It is the interest rate on loans of reserves from one bank to the other. Open Market Operations (OMOs) are the most important tool for central banks to conduct monetary policy. They are the main determinants of changing the overnight interbank interest rate and the monetary base. Through OMOs the banks conduct conventional monetary policy by either buying or selling securities from the banking system in the secondary market. In contrast to the Fed, BoE and BoJ, the ECB lets the national central banks of the euro area conduct its open market operations. Buying securities from the banking system expands reserves and the monetary base. The money supply increases and therefore lowers the short-term interest rate. It also works the other way around. Selling securities to the banking system lowers the amount of reserves and the monetary base, which in turn lowers the money supply and the short-term interest rate rises. The fluctuations of the reserves that banks hold in their system make it possible for central banks to control the short-term real interest rate. The second most important tool of monetary policy is standing facilities. Banking institutions can borrow from the central banks at the marginal lending rate. It is also possible for them to deposit reserves and receive interest at the deposit rate. Again, the ECB lets the national central banks conduct these standing facilities. In the Eurozone the lending rate provides a ceiling for the overnight interest rate, whereas the deposit rate provides a floor, also known as the ‘zero-bound’. This ‘corridor’ system limits severe fluctuations in the overnight rate. With

the use of standing facilities, a central bank is able to perform its role of ´lender of last resort´ to prevent bank panics. The interbank rate thus plays a fundamental role in the overall economy. Changes in the overnight rate can in turn influence the rates on deposits and loans set by banks and market rates. They also affect yields and prices of financial assets. These rates can potentially affect the economy through a variety of channels. This process is also defined as the “transmission mechanism” (Matthews, Giuliodori & Mishkin, 2013).

2.2 The channels of monetary transmission

Mishkin (1996) provides an overview of the transmission mechanisms of monetary policy in his paper. The first is the traditional interest rate channel. It is based on the traditional Keynesian ISLM model, developed by the economist John Hicks3, where IS stands for investment spending and LM for liquidity preference-money supply. An expansionary

monetary policy leads to a decrease in the real interest rate, lowers the cost of capital and thus causes an increase in investment spending. Aggregate demand then increases and leads to a rise in output. Keynes emphasizes that investment spending refers to business decisions as well as consumer spending on housing and on other durable expenditure. The Keynesian economist Franco Modigliani4 recognizes another transmission mechanism in which other asset prices and wealth transfer monetary effects onto the economy. He introduces two key assets besides bonds that are important for the transmission mechanism: the exchange rate and equity prices. When domestic real interest rate decreases, it becomes less attractive to deposit your money relative to foreign currencies. The value of the domestic currency depreciates, so that the prices of goods decrease. The lower value of the currency causes a rise in net exports and hence in aggregate output. As for the equity prices, when the money supply rises and the interest rates in bonds drop, investing in equity becomes more attractive and causing their prices to rise. Because the equity prices rise, consumers’ wealth will in turn increase and consumption should rise. Both these key assets produce a rise in aggregate output. Another transmission mechanism he mentions is through the credit-channels: the bank-lending channel and balance-sheet channel. With the bank-lending channel, expansionary monetary policy increases the reserves and deposits of banks, making them able to provide more loans. This will cause investment and consumer spending to rise. The balance-sheet channel allows monetary policy to lower adverse selection and moral hazard through rises in equity and thus in the banks’ net worth. Again this will lead to higher investment spending and aggregate demand. Thus the interbank rate indirectly has the possibility to increase the level of output

3

Source: See Hicks (1937)

4

and decrease the unemployment rate through these different channels (Matthews, Giuliodori & Mishkin, 2013).

2.3 The problem with conventional monetary policy

Conventional monetary policy has its limitations. When a financial crisis occurs, the

transmission mechanism might not work as smoothly as it should due to severe disruptions in the financial system. Implementing conventional monetary policy can therefore be a much more complex exercise than usual. Two main important issues are considered. Firstly, when the amount of losses that banks and borrowers face during a severe recession is large, the demand for reserves that banks hold might fluctuate severely. This could endanger the solvency of banks and borrowers, because depositors run to banks to withdraw their funds. The resulting contraction in deposits will lead to a bank panic. Investment spending reduces and therefore economic activity. Secondly, when the overnight rate touches the zero-bound, expansionary monetary policy will have little effect in this case, since the corridor system prevents the interest rate from going lower. The relationship between changes in the interbank rate and market interest rate breaks down. In such situations central banks need

unconventional measures to prevent further disruptions in the financial system, the risk of deflation and regain control on the economy (Joyce, Miles, Scott & Vayanos, 2012).

3.

Unconventional measures: Quantitative Easing

Unconventional monetary policy can take on many forms. One of the most common forms of unconventional monetary policy is a massive increase of the balance sheets of central banks (Joyce et al., 2012). When the official interest rate is almost at zero and concerns exist about the risk of deflation associated with the severe recession, central banks can choose to expand the size of their balance sheets. For example, during the period from 2001 to 2006, Japan used the term quantitative easing for the expansion of the balance sheets for the first time5. Non-standard monetary measures are mostly financed by the creation of new central bank's reserves. It is also simply referred to as printing money. The idea is that by targeting a high enough level of reserves, this would eventually spill over into lending into the broader economy, removing deflationary pressures and helping to drive up asset prices (Joyce, Miles, Scott & Vayanos, 2012).

This spill over into the economy, like conventional monetary policy, occurs through several various channels. Bernanke and Reinhart (2004) discuss three possible channels for stimulating the economy with QE. One of them is the “signaling channel”. The Central Bank

5

announces that it is committing to keep the size of its reserves high, well above the rate that is needed to hold the interbank rate at the zero-bound, until certain conditions are obtained. The announcement of the policy itself may affect asset prices. The central bank committing to these announcements is likely to form the expectations of agents of future economic conditions and policy actions and therefore affect the asset prices in financial markets. Another channel they mention is the “portfolio rebalancing channel”. Investors seek to rebalance their portfolio when money is an imperfect substitute for other financial assets. When long-term government bonds are purchased by the central bank, private agents hold less of the security and their yields decline. Subsequently, if the long-term interest rate of the security falls, its asset price increases. This eventually can create economic recovery through longer-term investment spending. Lastly, if the QE program is sufficiently aggressive and perceived by the public to be long-lasting, there will be expansionary effects on the economy through the “fiscal channel”. By purchasing government bonds through OMOs, the central bank replaces government debt that bears interest with reserves. If the public believes that this will persist, then the expected interest costs on the debt will decline. This means that the tax burden of the consumer will also decline and therefore more spending will likely occur (Bernanke and Reinhart, 2004).

3.1 Challenges of QE

Even though it seems quite promising that such a tool is able to at least mitigate a crisis, the central bank faces several challenges. The first is that such an approach poses a

communication challenge. Bernanke and Reinhart (2004) specifically note that besides the portfolio rebalancing channel, the signaling channel and the fiscal channel rely heavily on the credible commitment of the central bank. The channels require the central bank to commit not to reverse its purchasing program, at least until certain conditions are met. Another concern that Joyce et. al (2012) point out is that a high level of bank reserves might reduce lending between banks and leads them to malfunction. Reducing the level of reserves and avoiding severe inflation after recovery can be difficult. Furthermore, Joyce et. al state that the effect on the economy with QE is difficult to measure, since isolating its contribution is almost impossible. This is because at the same time more potential factors could have contributed to recovery, like fiscal policy. At last, the structure of each financial system has crucial

implications for the importance of the individual different transmission channels across countries and the effectiveness of QE. The impact of QE is therefore difficult to quantify (Matthews, Giuliodori & Mishkin, 2013).

3.2 QE in practice: Japan, United Kingdom (UK) and United States (US)

Despite the difficulty to trace the exact impact of QE, a number of studies provide estimates of the macroeconomic effects of previous implemented QE programs. In the next three subsections, each QE program of Japan, the United Kingdom and the United States and their transmission channels are discussed. Motivations for QE actions varied across their central banks and depended on structures of their specific financial systems and economies (Fawley & Neely, 2013). Discussing these programs will not only help to compare them to the actions of the ECB and predict the outcome of its current program, but also to learn lessons from them for future actions as well.

3.2.1 Japan

On March 19, 2001, the BOJ was the first central bank to adopt a QE program in response to an economic downturn triggered by the burst of the global IT bubble (Shiratsuka, 2010). The central bank, BoJ, implemented a program in which they purchased government bonds from banks amounting to some 13% of the nominal Gross Domestic Product (GDP) (Matthews, Giuliodori & Mishkin, 2013). Besides purchasing a large amount of government bonds from banks, it committed to maintain its policy rate at zero. Girardin & Moussa (2011) provide an empirical framework to quantify the effects of QE in Japan. They find that QE significantly helped to stimulate output and prices through the traditional interest rate channel and thus prevented further recession. Even when they take the implemented fiscal policy into account, their results remain valid, thus overcoming one of the challenges of measuring the impacts of QE. Furthermore, their result is in line with Bernanke and Reinhart’s (2004) argument that the program needs to be applied a long time for the benefits to appear in output and prices. They also conclude that QE should be coupled with financial reforms to have optimal effects on the economy. The results of the study of Oda & Ueda (2007) are also consistent with the main findings. They study the effects of the BoJ’s zero interest rate commitment and the QE program on the yields. They conclude that mainly the zero interest rate commitment led to a reduction in the medium- to long-term interest rates.

3.2.2 UK

Due to the collapse of the US sub-prime mortgage market and the reversal of the housing boom in 2008 the global financial crisis erupted. In response to the global financial crisis in late 2008, the BoE introduced quantitative easing as Large-Scale Asset Purchases (LSAPs) (Kapetanios, Mumtaz, Stevens & Theodoridis, 2012). The BoE announced purchases of mainly government bonds and gilts from non-banks and reduced its policy rate to 0.5%. The purchases assets represented about 14% of UK GDP. Joyce et. al (2012) conclude in their

article that the impact of QE that interbank borrowing rates and yields of governments bonds and gilts fell sharply by 100 basis points through the portfolio rebalancing channel in late 2008 in the UK. They also state that bond and equity issuance rose sharply, subsequently improving economy wide conditions. The results of Kapetanios et. al are also in line with these findings. They state that without QE, real GDP would have fallen more and inflation might have reached negative levels. Overall, they conclude in their paper that QE was an effective program during the financial crisis.

3.2.3 US

The global financial crisis triggered the Federal Reserve, the banking system of the US, to launch a set of non-conventional measures. The Fed lowered its target policy rate to its zero-bound and after the collapse of at the time the fourth-largest investment bank Lehman Brothers, the Fed purchased large quantities of long-term Treasuries, Agency bonds and Agency Mortgage Backed Securities (Krishnamurthy & Vissing-Jorgensen, 2011). The amount of purchased LSAPs by the Fed was comparable to that of the Bank of England. Gagnon et. al (2011) report that again the LSAPs led the 10-year US Treasury yield to decline of 91 basis points. Furthermore, Gagnon et al. find that the most important transmission mechanism that was primarily responsible for the decline in bond yields was the portfolio rebalancing channel. These findings are similar to that of Joyce et. al in the case of the UK. Both conclude that the programs were successful at stimulating economic activity mainly through the purchase of large assets.

4.

Eurozone

Now that some light has been shed on the QE programs in other countries, it is possible to compare them to QE in the EMU. The institutional factors and the environment of the Eurozone are introduced first to see how this framed the response of the ECB to the crisis.

4.1 ECB

The ECB’s operations are restricted by three of its important treaties and rules that it has set-up. Firstly, of particular importance during the crisis is the prohibition of “monetary

financing” (Article 123), which is laid down in the Maastricht Treaty. It prohibits the ECB from purchasing government bonds in the primary market, like the BoJ as mentioned before. The BoJ purchased bonds directly from governments. The prohibition would ensure

access means that the ECB cannot give public institutions better conditions than private-sector banks, when implementing refinancing operations (Article 124). Thirdly, the ‘no-bailout’ clause is the commitment not to bail out heavily indebted member countries of the European Union (Article 125). “As long as the bond markets assume that there will be no bailout whatsoever, they will demand different risk premiums according to country-specific risks” (Beck & Prinz, 2012). At last, the Stability and Growth Pact (SGP) together with fiscal provisions (Article 126) require member states to stay within the limits on government deficits (3% of GDP) and debt (60% of GDP). This mandate is specifically designed to maintain a stable monetary and economic union.

Even if the overall effect of QE on the economies of Japan, UK and US were positive, there is an ongoing debate whether such a program is suitable for a monetary union.

Comparing the ECB with the Federal Reserve will make it apparent what crucial differences there are in conducting monetary policy in a monetary union. Twelve district banks, the Board of Governors, the Federal Open Market Committee (FOMC) and circa 2800 commercial banks all are part of the Federal Reserve6. The Fed is a financial institution that works separately from the government. Even though the 50 states within the US are highly independent, they remain to be part of a federal republic with a powerful government. The different restrictions that the ECB faces are more complex, as the Euro area is not a federal union. 19 countries with separate parliaments are part of the Euro area. Each of them has different cultures, governments and political issues. These differences can cause frictions between the countries when implementing monetary policy. In fact, in 2006, Clausen & Hayo did research on asymmetric monetary policy effects in the EMU. They find differences in the transmission mechanisms in the Euro area, specifically in Germany, Italy and France. They find that with implementing a symmetric monetary policy, in the medium to longer term, the ECB is confronted with an asymmetric interest rate transmission. In Germany and Italy the effects are similar, whereas the transmission mechanism is significantly weaker in France.

4.2 Current crisis

The global financial crisis of 2008-2009 put a lot of pressure on the performances of central banks. While this was a complicated challenge for central banks overall, the ECB faced a set of complex institutional and political challenges. Its currency area, with (at the time) 17 member states, was fragmented politically. In the summer of 2012 the sovereign debt crisis erupted. Fragmentation through the Euro area countries regarding funding conditions for firms and households increased. Banks were not able to provide credit anymore and their balance sheet deteriorated. Moreover, investors lost confidence in some peripheral countries,

6

like Portugal, Ireland, Italy, Greece and Spain (also known as PIIGS). De Grauwe (2013) finds empirical evidence that these countries are hit by what he called “self-fulfilling liquidity crises”. Investors sold their government bonds in these peripheral countries, causing their interest rates to increase to unsustainably high levels. As a result, governments of these countries were not able to fund the rollover of their debt and therefore faced a liquidity problem (De Grauwe, 2013).

Especially in 2011 and 2012 this lead into a substantial outflow of euro deposits from banks in peripheral countries into banks in other core-countries, thereby amplifying

asymmetric shocks. It is therefore not surprising that this caused a major imbalance within its banking system (Joyce et al., 2012). This ultimately led to financial fragmentation. It

threatened not only economic growth, but also the ability of the ECB to manage monetary policy (Henning, 2015). Henning states that the European Union was missing three critical elements from the architecture of the Euro area in contrast to the United States. The Federal Reserve was provided support by the banking union, fiscal union and political union. The crisis exposed this incompleteness of the monetary union.

5.

An analysis of QE in the Eurozone

In response to the sovereign debt crisis, the ECB announced on September 6, 2012 the QE program by making the promise to purchase unlimited sovereign bond markets in the secondary market, the so-called Outright Monetary Transactions (OMT). However, the bond purchases would be conditional. The specific country must enter an agreement on a rescue vehicle: The European Stability Mechanism (ESM). The ECB restricted fiscal autonomy by imposing fiscal discipline of heavily over indebted governments by launching this permanent rescue funding program. In this way, the ECB acted more as a lender of last resort than the Fed. The characteristics of the programs constitute the outer limit of what is feasible within the ECB’s mandate. Cour-Thimann and Winkler (2012) believe that “The European Central Bank’s approach to date appears to stand out in that its non-standard measures in 2012 were not aimed at providing additional direct monetary stimulus to the economy but primarily at supporting the effective transmission of its standard policy.” They argue that the institutional environment with a bank-based financial structure and the multi-country context of the euro area framed the analysis of the transmission monetary policy and thereby the design of non-standard measures.

However, fierce criticism exists against the ECB acting as a lender of last resort. One of the most important arguments of the critics is that the government bond buying mixes fiscal policy with monetary policy, which is outside their mandate. One of those critics is De

Grauwe (2013). While he believes that the program reduced the risk of a financial implosion, he argues that the ECB endangered its political independence with the OMT program and prevented it from safeguarding price-stability, which is its core mandate. This could lead to higher inflation in the long-term. He claims that it is clear that the ECB wanted to both provide liquidity and avoid moral hazard risk. Beck & Prinz (2012) were also skeptic. They introduce The New Impossible Trinity within a monetary union. “An independent monetary policy, fiscal sovereignty and a no-bailout clause cannot coexist at the same time in the EMU”. They say that it is clear that the intentions of the programs were to prevent over indebted countries from defaulting, which violates the claim of independent monetary policy. To save the monetary union, they claim that one of the three principles has to be abandoned: the abolition of the no-bail out clause. If not, sooner or later the trinity will lead to the destruction of the monetary union. Above that, De Grauwe and Ji (2015) argue that the program failed to stop deflationary forces. The inflation rate became even negative at the end of 2014 (figure 1)7.

Figure 1. Inflation in US and Eurozone

On the other side, Henning (2015) argues that such an outcome is simply not consistent with fiscal dominance but a picture of monetary dominance and thus contradicting the critics, like De Grauwe, of the OMT program. Thus, that the ECB has acted within its monetary objective mandate. On June 16, 2015 the EU Court finally declared that the OMT program in 2012 is compatible with the law8. The Court finds that the program falls within the monetary policy of the ECB. In Henning’s opinion it is safe to say that it was a wise decision to launch the OMT program in 2012. Henning (2015) states that “the announcement alone was sufficient to calm the markets.” By signaling that it is ready to intervene in govern bond markets, it has induced

7

Source figure 1: ECB and Federal Reserve

8

confidence amongst the economy. This proves that the ‘signaling channel’ was a strong transmission mechanism in the Eurozone. Not only government bond yields have actually fallen, but also yields in other assets, without any actual intervention. Additional empirical research is done on the effects of the OMT programs, with conclusions that back up Henning’s argument. Falagiarda & Reitz (2015) did empirical research on the effects of the announcements of ECB’s unconventional programs in 2012. More specifically, on the

complications of the announcements for the sovereign spreads of stressed Euro area countries. They investigated how the announcements of the unconventional operations affected the sovereign spread of the PIIGS countries relative to Germany. Their results indicate that the announcements concerning the non-standard measures have reduced the sovereign solvency risk of all the previous mentioned countries, except for Greece. They also find that the OMTs have a stronger relation with the decrease of the differential between the German long-term bond yields and domestic yields as compared with other forms of unconventional measures. They eventually come to a conclusion that the ECB’s unconventional decisions succeeded in reducing the sovereign debt crisis in the Euro area. Also Altavilla, Giannone and Lenza (2014) find positive financial effects due to the OMT announcements and significant positive macroeconomic effects. They investigate the four largest countries in the Euro area; Italy, Spain, Germany and France. They find that the OMT announcements have statistically significant effects on economic growth in Italy and Spain. The spill-overs in France and Germany seem to be relatively limited.

To regain price-stability and avoid the excessively low inflation, Mario Draghi announced a QE program in January 2015, but with the actual purchase of government bonds in the secondary market. The purchasing of assets has officially started in March 2015. The ECB is currently purchasing assets composed of sovereign bonds and securities from European institutions and national agencies amounting to €60 billion, making the program more similar to that of the Federal Reserve and Bank of England. The economist Watt (2015) gives several reasons in his working paper to be skeptical about the current measures. He believes that sovereign-bond quantitative easing would have been much more effective in 2011, since the sovereign interest rates for peripheral countries like Spain and Portugal, are at historical lows at the moment and thus can not decrease much further, therefore reducing the scope of QE significantly. However, both the interest rates of Spain and Portugal decreased since the announcement of the program9, proving that the portfolio rebalance channel is essential in the transmission mechanism of QE. This also holds for the interest rates of the other GIIPS countries, except for Greece. The outcome in economic activity will resemble that of the United Kingdom and the United States.

9

Table 1. Long-term interest rates in the Euro area

As for the exchange rate channel: Watt argues that while a deprecation of this rate is an important transmission channel, it seems that it has already depreciated substantially against the US-dollar and other major currencies, a long time before the implementation of the program. Watt believes that the reason is that the program had been widely expected. He doubts whether growth will come from an increase in net exports. But again, looking at Figure 310, the euro has devaluated substantially against the US dollar since the announcement in January. It is highly possible that a sustained further impulse in the economy will come via net exports.

Figure 2. Exchange rate US dollar/Euro

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Since the large asset purchasing will occur sufficiently long (18 months), according to Bernanke and Reinhart (2004), the benefits should eventually appear in output and prices through the fiscal channel. The program was widely expected before the implementation in January. GDP has started increasing in the Eurozone since then11. A month after the implementation of the program, The Wall Street Journal states that growth forecasts have been continually increasing since the announcement of the program in January. The International Monetary Fund (IMF) expects the growth rate in the Eurozone to be 1.5% in 2015 and 1.9% in 2016. Furthermore, the peripheral countries like Spain and Ireland even expect to grow by 3% and 4% respectively this year.

Figure 3. GDP volume growth in the Euro area (economic growth)

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Furthermore, the main purpose of the program was to push the inflation rate up. The inflation rates prior to the program were negative. In January, the inflation rate was -0.6%12. While the inflation rate in the Eurozone was zero in April, it is still quite a progress compared to the rates prior to the implementation of the program.

Figure 4. Inflation rate in the Euro area

Watt may be right about the possible effects of the current measures, but knowing that previous measures contributed to the growth of the economy, without inducing hyperinflation in the long-term, they certainly do give some ground for hope. Although QE may not be ideal, it may be the best choice among the set of suboptimal options. What may be more debatable is not whether QE is the only solution, but on how the ECB will maintain fiscal sovereignty. Henning also argues that doing so will require further progress on the banking union. In November 2014, the ECB gave extensive support to the banking system by adopting new authority in banking supervision, but the ECB still has to continue on engaging strategically with national governments. This would require structural reforms, financial regulations and fiscal consolidation to complete the architecture of the monetary union (Cour-Thimann & Winkler, 2012).

6.

Conclusions

This thesis has reviewed the existing literature to predict whether Mario Draghi made the right decision by implementing the current QE program in the Eurozone. The main conclusion is that he did. Previous implemented programs by the BoE, BoJ and the Fed all were

successful at stimulating economic activity. Government bond yields decreased significantly due to the large purchase of assets and therefore prevented further recession. The main difference is that the transmission mechanisms operated through different channels. In the US and UK economic activity was stimulated mainly through the portfolio rebalance channel, whereas in Japan through the signaling channel. Furthermore, the OMT programs

implemented by the ECB in 2012 in response to the sovereign debt crisis boosted confidence into the economy of the Eurozone through the signaling channel, without the actual purchase of assets. Previous empirical studies on the effects of the program in 2012 have shown that several peripheral countries have grown significantly and that the program succeeded in reducing the sovereign debt crisis in the Euro area. While critics were worried whether the program would endanger its monetary dominance, the low inflation by the end of 2014 shows that such an outcome is not consistent with fiscal dominance and that the ECB acted within its mandate. While the outcome of the current QE program is not guaranteed, we do know that it at least will again boost confidence and that without the program, the current state in the monetary union will definitely worsen. With the LSAPs, it is highly possible that the current program will also stimulate economic activity through the portfolio rebalancing channel, resembling the outcome in the UK and US. Above that, with the devaluation of the euro against the dollar, a further impulse into the economy will occur through the exchange rate channel. Even though QE seems like a good policy compared to other policies at the moment, the European Union still has to find a way to improve the overall structure of the monetary union by making a progress on the banking union. Further research is necessary in the future to investigate whether the ECB has reached it goals with the program.

7.

References

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