Coldwater Economics: ECB's QE: More Magic Than Mechanics

So, will it work?

It would be easier to answer that question if we could form a clear idea of what Mr Draghi thinks this quantitative easing will achieve and how it will achieve it. That is not easy.

It seems to me that throughout this financial crisis there have been four models about what QE might achieve:

The first is relatively straightforward: quantitative easing has been (in the US and UK particularly) a way of publicly guaranteeing the solvency of potentially distressed financial systems.
In the second model the central bank hopes to master the longer-end of the bond market, driving investors are driven into riskier instruments, and thus driving down risk premia. In terms of the economy, by depressing bond yields below 'fair value' rates, central banks and economists entertain the hope that savings rates would be cut, and investment spending encouraged. In both the US and UK this has happened very slowly, very late in a business cycle, and to the extent that it has happened at all there is no certainty (and limited probability) that QE played a key role in changing savings/investment choices.
The third model involves using QE to announce a public 'regime change' of monetary policy which, by itself, manages to raise inflationary expectations.
The fourth model is quite different and the polite financial community pretends it hasn't noticed it: in Japan, QE is being used as a way in which the central bank can achieve hegemony over/functionally replace a banking system which seemingly cannot be revived from its decades-long coma.

Which of these engines does the ECB think it has set in motion?

The first move is to listen to what Mr Draghi had to say. The key passage, it seems to me was this: “while the monetary policy measures adopted between June and September last year resulted in a material improvement in terms of financial market prices, this was not the case for the quantitative results.” What does he mean by quantitative results? He could mean either there was insufficient positive results in terms of credit (and he's right, bank lending to the private sector fell 1.4%, or by Eu151 bn over the 12m to Nov), or alternatively, the 'quantitative result' he may be referring to could be economic output and economic growth.

Nor did Mr Draghi get significantly more coherent as he outlined what he thought might be achieved: QE would

decisively underpin inflationary expectations
ease financing conditions for firms and households
'reinforce the fact that there are significant and increasing differences in the monetary policy cycle between major advanced economies.'

That last is simply obscure: the obvious explanation is that he is simply talking down the Euro – is this really what he intended?

If from all this you can construct a clear set of aims, and a picture of the mechanisms by which the Eu60bn per month buying of assets will achieve those aims, you are one step ahead of me. But if pushed, I would say he is relying on a 'regime change' to push up inflationary expectations, whilst hoping that ECB's bond-buying will somehow be passed on to firms and households.

There are two problems getting in the way of that second hope. The first, of course, is that the longstanding expectation that ECB would eventually be driven to something like QE has already depressed both sovereign Eurozone bond yields, and risk premia. Ten-year Eurozone sovereign bond yields are only around 50bps, with the risk premium of 10yr BBB bonds approximately 100bps, and, for troubled sovereigns such as Spain, around 140bps. The marginal impact of squeezing these premia down further can surely be only slight.

The second problem is that even as national central banks buy bonds from their own financial system, the receipts are likely to pool in the most credit-worthy systems. Within the Eurozone, that means the German banking system, where we will be able to track the process by the Bundesbank's Target 2 balance with the ECB. Outside the system, the Swiss National Bank is making a radical assumption that plenty of the ECB's QE is coming its way. For evidence, consider changes in the ECB's balance sheet: