Central bank blues

On Monday (09.03.2015), the European Central Bank begins its long-anticipated program to buy sovereign bonds on secondary bond markets - i.e. previously issued government bonds held by institutional investors like banks or insurance funds. In central bankers' jargon, this is called "quantitative easing," or QE.

The ECB's plan is to pump 60 billion euros ($65 billion) into the financial markets each month, by trading central bank reserve money (a form of electronic cash) for bonds. That's set to continue until at least September 2016, which means at least 1.1 trillion euros will be put into the hands of investment managers - who will have to find some alternative investments to make with the money.

The bond-purchasing program's goal is to push inflation back up to just under two percent - at the moment, there's consumer price deflation averaging 0.3 percent across the eurozone.

The ECB appears confident that QE will succeed in this aim. On Thursday last week, at the ECB's governing board meeting in Nicosia on Cyprus, the central bank revised its projections for both GDP growth and inflation in the eurozone upward: The inflation rate is projected to go up to 0.7 percent for this year, and GDP growth from 1.0 to 1.5 percent. But are the new projections just a case of whistling in the dark?

Who wants the ECB's money?

There are in fact serious doubts as to whether the ECB will actually be able to meet its targets, or if, instead, the bond-purchasing program will have effects that will make a structural recovery of the eurozone more difficult.

For a start, many observers doubt whether the ECB will even be able to find willing sellers for 60 billion euros a month of bonds. Sovereign bonds - especially those of the core eurozone member states, like Germany - may soon become rather scarce on secondary markets: Neither domestic banks and insurance funds, nor foreign central banks, will have much incentive to sell their government bond holdings to the ECB. The older bonds with long maturities and decent interest rates, in particular, will probably be held rather than sold.

Moreover, experts question whether a flood of central bank reserve money, pumped into the hands of players in secondary financial markets, can generate a stimulus at all. It probably won't lead to any boost in their lending activities to real-economy businesses or households, for two reasons: First, banks have recently been obliged to increase their core capital reserves - the amount of shareholders' money, including retained earnings, which is available to cover possible loan losses - and they're still adjusting their balance sheets accordingly. That means they're being cautious about lending.

Second, a great many households and businesses are already heavily in debt, and on a net basis across the eurozone private sector, it's quite possible that there just isn't any appetite for more debt. On the whole, the eurozone private sector probably wants to deleverage, not lever up further.

Eurozone goods and services cheaper in foreign currency terms

Commercial banks are also unlikely to pass along the benefits of the ultra-low core interest rates the ECB is generating through its QE program. Even before the program started, the mere announcement that QE could soon begin has kept interest rates extremely low.

That core interest rate is what the ECB charges commercial banks to borrow from the ECB. It is not, however, what commercial banks charge their customers.

Commercial banks are keeping the interest rates they charge their own borrowers - businesses and households - relatively high, in order to generate a fat margin. The reason isn't simply greed: in countries like Italy or Spain, well over 10 percent of all existing bank loans are in arrears or in default, which punches a big hole in bank balance sheets. A fat margin on new loans helps banks earn the money needed to repair their balance sheets.

But there's one thing that could inadvertently help the ECB meet its eurozone growth targets: The euro has become much cheaper on foreign exchange markets as a result of the ECB's announcement of its QE program. More euros flooding financial markets - including foreign exchange markets - means euros must get cheaper, in line with the principle of supply and demand. That's why the currency has lost value recently. And that helps European exporters looking for customers in the Americas or Asia.

The decline in the relative value of the euro is one of two main reasons, along with the dramatic fall in oil prices, that have led to somewhat more positive macroeconomic indicators lately. Those two factors are also the basis for the spate of upward revisions in economists' prognoses for eurozone GDP growth this year.

Unfortunately, none of this will be enough to generate anything more than a tortuously slow reduction in European unemployment rates - which average 11.2 percent across the eurozone, but are much higher in the worst-hit countries like Spain, Portugal and Greece.

Structural reforms remain necessary

And so we come to the counterproductive effects of the ECB's flood of money. Among other things, there's reason to be concerned that as the additional liquidity flows into financial markets, the result will be asset price bubbles - overheated stock prices, overheated real estate markets. Bad financial risk assessment and malinvestments become more likely.

There's also a risk of turbulence in foreign exchange markets arising due to competitive devaluations, as other currency regions try to counter the cheaper euro to avoid losing market share to European exporters.

Real-economy investors worried about such risks will probably hold off on major investments. Yet the lack of such investments is the main weakness of the eurozone economy.

But things could get even worse, if eurozone member states succumb to the illusion that the bond-buying problem is all that's needed to restart the eurozone's growth engines. The structural weaknesses in the southern eurozone cannot be fixed by expansive monetary policy - the lack of competitiveness on global markets due to high tax burdens, bloated state administrations, barriers to competition in various professions, labor market rigidities... all these factors require structural reforms.

That's particularly important in major eurozone economies like France and Italy. Without robust structural reforms, the growth and inflation goals of the ECB's QE program may not be attained, regardless of how many bonds the central bank buys on secondary markets.