This week, the European Central Bank will authorize a fresh program of quantitative easing in Europe. My impression is that the structure of this venture will be far different from what seems to be commonly envisioned (and priced into an exchange rate that is has already overshot to the downside). The political realities for Germany have led it to shift its focus from opposing QE outright to changing the structure under which QE will proceed. It’s that potential impact on the structure of QE that seems underappreciated. Germany has two primary interests here. One is to ensure that any losses are borne by the individual member states, and the second is that as few euros as possible are created with the backing of questionable sovereign debt. Put simply, Germany’s agreement to allow QE to proceed is likely attached to particular strings that limit its exposure to the sovereign debt of its less credit-worthy neighbors.
Under Article 16 of the Protocol that established the European System of Central Banks (ESCB), the ECB Governing Council has the exclusive right to authorize the creation of euros, but either the ECB or the individual national central banks can issue those euros. The ECB will authorize a large QE program this week, but my impression is that the details will leave the ECB itself responsible for executing only a fraction of the announced program, with the remaining majority of the program (perhaps 60-75%) being nothing more than the option for each national central bank to purchase its own country’s government bonds, at its own discretion, and its own risk. Moreover, that option is likely to be limited to something on the order of 25% of the outstanding government debt of each respective country.
With German government debt trading at negative yields out to maturities of 5 years, German buying of German debt would essentially guarantee a loss to the Bundesbank. As a result, the likelihood that Germany will act on the option to buy that debt seems rather slim. The same argument holds, if to a lesser extent, for other credit-worthy countries in the Eurozone, which means that the bulk of that option will be taken up by smaller and less credit-worthy members. With a cap of perhaps 25% of total government debt, the actual size of QE when implemented is likely to be dramatically smaller than whatever number is announced this week. That certainly doesn’t rule out an ebullient knee-jerk response to whatever massive number is announced, but pay attention to the details, because they are likely to have a significant effect on what happens next. We’ll see.
