ECB’s Poor Justification of Quantitative Easing

Since the 2008 crisis, the balance sheets of the Fed, ECB and BoE have more than doubled due to massive asset purchases. The S&P 500 and other indexes have followed the same path, and so did the wealth of speculators, asset managers and equity-holders. Many have since criticised the effects of quantitative easing (QE), yet central banks still cling to this controversial policy. One of these critiques says that QE increases economic inequality as a process of trickle-down economics. This article will analyse ECB’s 2019 opinion on the matter and come to two possible results: either QE does not result in economic inequality, but ECB’s research is insufficient, or QE does result in economic inequality, and central banks should thus choose a different monetary policy to keep both its reputation and the economy healthy.

The process of QE involves purchasing long term securities --  usually government and private bonds -- from the open market. The goal of this unconventional move is to provide liquidity to a low-interest market and destroy deflationary forces in situations where orthodox monetary policies do not suffice anymore. Moreover, by purchasing massive amounts of securities, central banks drive their prices up and their yields low. This creates an incentive for governments, businesses and households to borrow more money from commercial banks and inject them into the economy by spending or investing.

Even though QE is currently central banks’ largest tool, it does not go far in history. On March 19, 2001, the Bank of Japan set upon to solve its stagnant economy by adopting a never-tested policy which we now know as QE. Many were sceptical of its potential impact, as interest rates were already depressed. Even though the Japanese economy recovered in five years, there are still intense academic disputes on the efficiency of the experiment. Nevertheless, central banks have resorted to it both in the 2008 financial crisis and in the current COVID-driven economy. However, without doubting QE’s impact on interest rates, inflation and the bond market, it is essential to reflect on its impact on the people.

A 2015 report from the Financial Times scrutinised the impact of QE on wealth inequality. It concluded that QE had made the rich richer by boosting the values of financial assets and property. Paul Marshall concluded: "Banks have been the biggest beneficiaries, with their 20- or 30-times leveraged balance sheets. Asset managers and hedge funds have benefited, too. Owners of property have made out like bandits. In fact, anyone with assets has grown much richer. All of us who work in financial markets owe a debt to QE." As with other articles on inequality, it has sparked much controversy between economists, academics and politicians alike with the most profound one being a 2019 research bulletin from the European Central Bank (ECB) itself.

In the paper, the ECB argues that QE has not only not increased inequality in the Eurozone but also slightly decreased it. There are two main points made, which say that QE has decreased inequality by (i) lowering unemployment and increasing income of the employed, and (ii) increasing median net wealth by positively impacting the house prices. However, as will be shown, ECB’s attempt to justify its practices has fallen short on both points.

(i) Unemployment and increase in income

According to the ECB, Eurozone’s inequality has decreased, as the lowest economic quintiles experienced an unemployment rate decline 1.5% higher than the wealthier quintiles. Decreasing unemployment rates go together with increasing income, as the sudden wage-earning boosts household income. The ECB demonstrates this theory through a 0.2% decrease in the income Gini coefficient. Not only does this percentage not result in any tangible change, but there is another, a more significant flaw with this point. That is the choice of income Gini coefficient instead of the wealth Gini coefficient. As wealth inequality is much higher than income inequality, the wages employees get will never exceed the net wealth gains of their employers, property owners and managing directors of investment banks who all greatly benefit from QE. The ECB unsuccessfully tackles this problem in its second point.

(ii) Increase in median net wealth

The ECB argues that the lowest quintile experienced the highest growth in median net wealth (~2.5% against ~1% in wealthier quintiles). As true as it is, a 2% growth of €1,100 will always result in less net wealth increase than a 1% growth of €512,000. Without realising this mistake, the ECB attributes the growth of rising house prices which make up ~75% of total household assets in the Eurozone. However, the argument bears minimal weight without mentioning household liquidity. The fact that houses make up ~75% of households’ assets does not say anything about the mean number of houses owned by different quintiles and their ability to convert them into cash. It will always be easier for a wealthy family with four houses to sell one than for a low-income family with but one home. An illiquid asset may appear as wealth gain on paper, but it will be of no use to struggling parents. In sum, the ECB’s version of trickle-down economics may have slightly decreased Eurozone’s income inequality in the short term. However, a careful analysis of the wealth Gini index was conveniently left out as was the long-term impact of QE.

With the second wave of Covid-19 around the corner, central banks will need to resort to more innovative solutions than mere artificial pumping of financial institutions. One could argue that central banks should help the economy regardless of the people’s opinion, but it is important to note that it is the people’s trust in the financial system which makes it function well. Ten years after the 2008 crash, two-thirds of British people do not trust the banks to work in their best interest, and it is no different in other countries. Thus, if ECB’s research is incomplete, injecting £745 billion will likely not foster this situation. The stock market may appreciate it, but the people will not.

By Jonas Nepozitek, VP at the King's Banking and Finance Society

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