Against the ECB’s bazooka lies a solid wall of obstacles. The first is an impaired banking system, muddling through €1tn of bad loans with balance sheets still three times as large as the eurozone economy. The second problem is a lack of corporate investment, which remains insensitive to lower interest rates. The third is shallow capital markets, a bottleneck against ECB liquidity trickling down to small and medium businesses, responsible for 80 per cent of job creation.
This means monetary stimulus is necessary but not sufficient, as Mr Draghi himself said earlier this year. To be fair, QE has had some success so far. It has lowered the euro and supported exports, both in Germany and the periphery. But currency depreciation is temporary and dependent on the reactions by other central banks. You can win a battle, but winning the currency war is a different story.
If exports aren’t enough, the other transmission channels of QE remain impaired. First, eurozone banks are not lending. Lending volumes to non-financial firms are flat this year after a jump during the first quarter, as banks still hold over €1tn of bad loans on their balance sheets (10 per cent of GDP).
Restructuring or selling these bad loans is difficult due to inefficient bankruptcy frameworks, while progress to develop alternatives to banks — the Capital Markets Union (CMU) plan — remains slow. Finally, and unlike what Mr Draghi said in last week’s press conference, low interest rates support banks with a one-off gain on government bonds and other securities they hold, but they also erode profitability and capital over time, as recently highlighted by the Bank for International Settlements.
The wealth effect is weak too: higher asset prices reward people who own assets in the first place and the wealthy tend to save more of their gains, reducing the impact of QE on demand. The most important missing piece in the puzzle is corporate investment, down 20 per cent since the crisis. [...]
There are three ways to make QE work. One is to boost monetary stimulus with public investment. European governments have little fiscal ammunition for large-scale stimulus. A credible co-ordinated plan could provide the right signal effect to kick-start private investment, coupled with QE. [...]
The second option is to deepen Europe’s capital markets so central bank liquidity can flow to Europe’s SMEs. The CMU plan aims at developing this plumbing but implementation is proving complex, given each country’s legal and regulatory frameworks.
The third solution is to attract private investment with a combination of reforms and lower taxes. This has worked in Ireland and Spain. Like for public investment, a successful plan needs to be clear and long-lasting. Where incentives have been complex and frequently changing, such as in Italy, they have failed.
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