Draghi’s Dilemma

Quantitative easing, the label now used for large-scale purchases of bonds by a central bank, is not a new phenomenon. The Federal Reserve, the Bank of Japan and the Bank of England have done it. So why so much attention on whether the European Central Bank will launch its own version at its Jan. 22 meeting?

Because Europe, again, is the biggest economic threat to global economic growth right now. And because the ECB – responsible for a currency shared by 19 sovereign governments – is in a much more complicated situation than the Fed or other central banks.

If central banking were an Olympic event judged by the degree of difficulty, the ECB would get good scores. “But it is not,” says  Mohamed el-Erian, chief economic adviser at Allianz and a former top PIMCO executive. “Central banks will be judged by their success in delivering on ambitious macroeconomic objectives with frustratingly partial means. The prospects aren’t reassuring.”

In one respect, the ECB faces a very clear case for QE. Its mandate is price stability, defined as inflation close to but under 2%. But consumer prices in the euro area fell by 0.2% in the 12 months of 2014, according to the latest Eurostat estimates.

And even excluding (falling) oil prices and (flat) food prices, inflation was running at just 0.8%. The ECB’s interest rates are already as low as they can go so QE would seem the obvious next step if it takes its mandate seriously. If not now, when?

So why the hesitation? On the economics, QE might not do much good, as former Fed governor Jeremy Stein noted in a Wall Street Journal video interview.

Long-term interest rates – the target of QE-style bond purchases – are already very low in Europe. Unlike the U.S., where lots of companies borrow in the bond market, Europe is more bank-centric, and it isn’t clear that QE would do much to get banks lending again. Then there are all sorts of issues unique to Europe: There is no analog to the U.S. Treasury bond or British gilt for the ECB to buy. If it buys a basket of sovereign European bonds, it might end up with bonds that may not be repaid in full (Greece, for instance.) But if it doesn’t buy bonds from every country that uses the euro, it undercuts the whole concept of a common currency.

Then there are the politics, the skepticism inside the ECB governing council, the resistance from Germany to buying government bonds of other euro-zone countries, the argument that the ECB should keep the heat on Italy and Spain, the rise of euro-skeptic political parties and so on.

QE is likely to work if it’s got that “shock and awe” feel to it, a surprisingly strong move that delivers on ECB President Mario Draghi’s famous “whatever it takes” promise and is accompanied by a new political will among elected European governments to do their part on the fiscal and structural-reform fronts. That’s what happened in Japan when a newly elected government appointed a new and aggressive central banker: Haruhiko Kuroda’s QQE, as the Bank of Japan calls it, might not work, but was the manifestation of a  new “whatever it takes” consensus in Tokyo.

And here’s the bottom line: Constrained by dissent on the ECB governing council and QE skepticism in the government of Germany, Mr. Draghi probably can’t deliver “shock and awe.” After dropping so many hints in public and raising market expectations, Mr. Draghi is likely to announce the launch of some version of QE on Jan. 22, perhaps leaving crucial details for later.

But if it looks like he had to dilute his version of QE to keep the Germans and their allies happy,  QE will be less likely to have the desired effects –on inflation expectations and on waning public confidence in the euro-zone economy, its institutions and its politicians.