Quantitative easing in a monetary union - not as easy as it sounds

The Eurozone is heading gradually off on a path that might require the authorities to consider a large scale QE policy.

If government debt becomes too large to manage, then one way out of the pickle is to create lots of inflation that will erode the stock of debt over time. It is smoke an mirrors or course, as it does not create any wealth, but simply creates a transfer from bond holders to governments. The losers tend to be pensioners, since they are the bond holders in society in the main and receivers of fixed income directly or indirectly from long term government bonds. But that is a distributional issue tangential to the purpose of this post.

This post is to ask a more practical technical queston. How exactly would QE work in the Eurozone? Normally, say in the US or UK, the Central Bank would buy government debt for new money. This increases the amount of money in circulation, which if enough, will create more than enough liquidity which will then, in effect, be given away by banks who in the end won't be able to find any counterparties to deposit it with - because all the banks will have more liquidity than they want or need.

More money in the economy per unit of output produced will mean the ratio of Euros to output (GDP) will increase. The value of money will erode, which is inflation. In a previous post I have described how inflation then leads to a reduced burden on those in debt who have borrowed over a long term. Basically this means governments.

Now what is interesting here from a Eurozone perspective is that there are usually two distinct things going on here. There is the liquidity and eventual inflation that the QE produces. However, just as importantly, the act of buying government bonds for money retires some government debt. The Central Bank is owned by the government, so those bonds purchased can effectively be written off. In other words, what has happened is that the government, via the Central Bank, has called in its bonds and swapped them for an extremely cheap form of liability, or debt, that it will never have to repay - money; Dollars, Pounds etc. which are merely another form of government liability (although sitting on the balance sheet of the central bank).

Do you start to see the question here?

In the US the Fed would buy Federal bonds. These are debts owned by all Americans. They can be retired (swapped) for fresh dollars in the manner I described. The US government debt is both reduced and deflated.

However, what of the Eurozone? Whose government bonds will be purchased? And after that, can we employ the same logic and retire those debts, letting some countries off the hook?

The answer to the first question is that we can and probably would buy the debt of those countries that are prospectively insolvent , that have too much debt. Step forward Ireland. The answer to the second question is that we can, but with the full realisation that the rest of Europe would be bailing our Ireland, Portugal, Greece, etc. by swapping the debt incurred by those nations for liabilities (Euros) owned by all of Europe. The inflation that would ensue would adversely effect all the normal losers in this process (those pensioners in particular that I mentioned), but those losers in Ireland will have benefitted by the reduction in Irish debt that will allow.

Who will like this solution?

• The Irish, Greek, Portuguese, Spanish governments
• Irish, Greek, etc. state and civil service pensioners
• Irish, Greek, etc. taxpayers

Who will not like this solution?

• German pensioners
• German taxpayers

Those who might or might not like this solution?

• Irish, Greek etc. private pensioners (they will have their pensions eroded by inflation, but governments will be better able to afford to maintain higher level of public services - especially health)

It sure makes QE in Europe one hell of a political minefield, something I have not yet seen mentioned in the media.


Just as an aside. Where might a QE program start? Where better than a purchase of the €80bn plus in Irish government debt held by the ECB in Repo. agreements?