More than three years after the financial crisis that erupted in 2008, who is doing more to bring about economic recovery, Europe or the US?
The US Federal Reserve has completed two rounds of so-called “quantitative easing,” whereas the European Central Bank (ECB) has fired two shots from its big gun, the so-called long-term refinancing operation (LTRO), providing more than 1 trillion euros (US$1.3 trillion) in low-cost financing to eurozone banks for three years.
For some time, it was argued that the Fed had done more to stimulate the economy, because, using 2007 as the benchmark, it had expanded its balance sheet proportionally more than the ECB had done. However, the ECB has now caught up. Its balance sheet amounts to roughly 2.8 trillion euros, or close to 30 percent of eurozone GDP, compared with the Fed’s balance sheet of roughly 20 percent of the US’ GDP.
However, there is a qualitative difference between the two that is more important than balance-sheet size: The Fed buys almost exclusively risk-free assets (such as US government bonds), whereas the ECB has bought (much smaller quantities of) risky assets, for which the market was drying up. Moreover, the Fed lends very little to banks, whereas the ECB has lent massive amounts to weak banks that could not obtain funding from the market. In short, quantitative easing is not the same thing as credit easing.
The theory behind quantitative easing is that the central bank can lower long-term interest rates if it buys large amounts of longer-term government bonds with the deposits that it receives from banks. By contrast, the ECB’s credit easing is motivated by a practical concern: Banks from some parts of the eurozone — namely, from the distressed countries on its periphery — have been effectively cut off from the interbank market.
A simple way to evaluate the difference between the approaches of the world’s two biggest central banks is to evaluate the risks that they are taking on.
When the Fed buys US government bonds, it does not incur any credit risk, but it is assuming interest-rate risk. The Fed acts like a typical bank engaging in what is called “maturity transformation:” It uses short-term deposits to finance the acquisition of long-term securities. With short-term deposit rates close to zero and long-term rates at about 2 percent, the Fed is earning a nice “carry,” equal to about 2 percent per year on bond purchases totaling roughly US$1.5 trillion over the course of its quantitative easing, or about US$30 billion.
Any commercial bank contemplating a similar operation would have to take into account the risk that its cost of funds increases above the 2 percent yield that it earns on its assets. The Fed can determine its own cost of funds, because it can determine short-term interest rates. However, the fact that it would inflict losses on itself by increasing rates is likely to reduce its room for maneuver. Its recent announcement that it will keep interests low for an extended period thus might have been motivated by more than concern about a sluggish recovery.
By contrast, the ECB does not assume any maturity risk with its LTRO, because it has explicitly stated that it will charge banks the average of the interest rates that will materialize over the next three years. However, it does take on credit risk, because it is lending to banks that cannot obtain funding anywhere else.