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How European Central Bank QE Works

European financial authorities have high hopes for quantitative easing across the Eurozone, but few know exactly how European Central Bank QE works.

ECB QE is a very different animal than similarly named methods in the United States and Japan. European Union treaties and German outcry over inflationary "money printing" measures have forced the ECB to pursue a program with a number of limitations.

When ECB president Mario Draghi announced ECB QE in a January 2015 ECB meeting it sounded rather simple.

ECB QE would be a 60 billion euro ($66.2 billion) a month bond-buying program. It would last from March 2015 to at least September 2016, aimed at bringing inflation up to a target rate of 2%. This would, over 19 months, add 1.1 trillion euros ($1.2 trillion) to the Eurozone financial system.

Those numbers are worth a closer look, but first, here's how QE works…

How ECB QE Works – Part 1: The Basics of QE

It's important to understand that ECB QE is not "money printing." And even just by itself, it's not inflationary.

Here's how it works. The European Central Bank – or one of the Eurozone member's national central banks – will transfer a government bond from a commercial bank's balance sheet to its own. The bond will show up on the asset side of the central bank's balance sheet. Then the central bank will credit the commercial bank's reserve account the value of that bond.

The central bank's balance sheet will increase on the asset side by the value of the bond, and the liabilities by the increase in value of the commercial bank's reserve account.

But in this transaction, the commercial bank's balance sheet doesn't change at all in value, only in composition. It is an asset swap. The commercial bank swaps a less liquid asset (a government bond) for a more liquid asset (euros).

All this does is increase liquidity within the commercial bank. It allows the banks a larger capacity to issue more loans.

As firms and households borrow that money and credit expands, more money is moving around in the economy. This is known as the velocity of money. It's this velocity that's supposed to help fight deflation and get dollars moving in the private economy.

In short, QE is an effort to facilitate a higher velocity of money by giving banks more lending capacity.

Now, here's how European Central Bank QE works…

Join the conversation. Click here to jump to comments…

  1. Lee Adler/The Wall Street Examiner | April 6, 2015

    This post was definitely a helpful explainer.

    I would take issue with the statement that "It's important to understand that ECB QE is not "money printing." Also, the theory that QE will stimulate velocity is wrong. QE causes velocity to plunge because money supply grows faster than GDP or even potential GDP. Velocity is a derived number, essentially GDP/M. It's a meaningless construct. As long as central banks are printing mass quantities of money, V will continue to fall. When they stop printing, V will rebound.

    Where did the ECB (or NCBs) get the funds to buy the bonds? Answer- They printed it. It did not exist before the purchase transaction. The ECB's balance sheet expands as a result. Central bank purchases of government bonds during periods when governments are in deficit and financing spending with debt, are quintessential money printing.

    The purchase transaction itself does not expand the banks' balance sheets as Mr. Bach points out, but governments spending the funds they raised with those bond issues does. It's why US money supply expanded almost precisely dollar for dollar with Fed QE, and why bank balance sheets, and hence money supply, will grow as a result of this program UNLESS the banks don't use the funds to pay down debt, particularly ECB debt. In that case, both Euro money supply, and the ECB's total assets will do no better than stagnate.

    The ECB only prints the money to buy the paper. After that, it's out of the ECB's hands. The ECB has no control over what the banks do with the cash. If the banks opt to use the cash to pay down debt, then the ECB's program will be an abject failure, just as all its other recent programs have failed to cause its balance sheet to grow. It would be an especially embarrassing failure if the banks use the cash to pay down outstanding ECB credit. The negative deposit rate acts as an incentive for them to do so.

    The ECB, with its money printing and negative deposit rates has created, if not a Catch 22, then at least a Gordian knot. QE does not and cannot force banks to lend. Banks can lend whenever they want, without any central bank cash whatsoever. What banks need to make loans is qualified loan demand. Without that, they won't lend, or if they do, they'll just create more bad debt.

    The only thing QE can do, and does do, is inflate asset prices. The question is how long it will be before they finally grow tired of seeing asset prices inflate into bubbles. The Fed has already reached that point. That leaves the ECB and BoJ. When they finally get exasperated enough by the failure of QE to achieve the stated goals, or worried enough about dangerously bloated asset prices, they will finally pull the plug.

    That's when things will get really ugly.

    • Jim Bach | April 7, 2015

      Hello Mr. Adler,

      Thank you for the thoughtful comment. I would like to point out that this is merely an "explainer" as to how QE works in the Eurozone. We are not extolling its merits or endorsing it as an effective policy tool. This piece was merely seeking to make sense of a complicated topic made even more complicated by the nuances of the Eurozone.

      This is just a look at the rationale and assumptions behind its implementation. For our take on QE's efficacy I'd like to point to a story we wrote on this in December: http://moneymorning.com/2014/12/08/why-qe-doesnt-work/. I think you'll see that that article does speak to your point that without "qualified loan demand," QE won't work.

      Thanks again for your insight,
      Jim B.

      • Lee Adler/The Wall Street Examiner | April 7, 2015

        Your piece really laid out the particulars of the ECB program nicely. It's a Rube Goldberg contraption that's bound to have negative unintended consequences.

        I had an error in the phrase: why bank balance sheets, and hence money supply, will grow as a result of this program UNLESS the banks don't use the funds to pay down debt, particularly ECB debt.

        Should read " UNLESS the banks use the funds to pay down debt, particularly ECB debt."

      • joao | April 7, 2015

        You said ECB QE is not money printing but then we look at reality and see that its actually the opposite of the sentence you just said. In other words you said the opposite of reality and the truth, you said something that is false and you didn't correct it yet.

        • Gabriel | April 8, 2015

          ECB QE is not money printing.
          EZ rules dictate that money can never be printed.
          So the money was created "electronically" instead… meaning they create the money by simply typing it into their accounting system instead of printing.
          Hope this clears things here.

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