Starting this month, the European Central Bank (ECB) will be buying up a lot of European corporate bonds. We look at why it has decided to do so and what effect the measure may or may not have short-term.
On March 10 of this year, the European Central Bank (ECB) announced it would add a “corporate sector purchase program” (CSPP) to the “asset purchase program” (APP) it had been operating for about a year.
Under APP, the ECB had been buying about 60 billion euros a month ($67 billion) in sovereign bonds from secondary bond markets – i.e. from commercial banks, pension funds, and other investors. APP involved ECB buying government bonds from eurozone member nations in vast quantities using its flexible balance sheet. The ECB doesn’t need to save up money in order to buy financial instruments from third parties, by the way; it can create “reserves,” or central bank money, ex nihilo, in any quantity it deems appropriate.
The idea behind APP was to drive up sovereign bond prices by flooding money into the sovereign bond market, which reduces the implied interest rate on sovereign bonds. That makes it cheaper for governments to finance themselves – i.e. it reduces the interest rate governments need to pay on new sovereign debt issues, which helps their budgets – and it also motivates institutional investors to try to find something more profitable to invest in with the cash that floods in.
Corporate bonds
The ECB plans to continue APP for at least another year, and starting this month, it will add CSPP to its program. It will also be increasing the total size of its monthly purchases to 80 billion euros.
“In combination with other non-standard measures, the program will provide further monetary policy accommodation and help inflation rates return to levels below, but close to, 2 percent in the medium term,” the ECB said in an April 21 press release.
In plain English, that means the ECB hopes that flooding the European corporate bond market with vast sums of ECB money will help move the needle on consumer price inflation, which remains stuck at about 0.1 percent – well below the 2.0 percent target ECB, like most modern central banks, believes is necessary to keep an economy growing. That’s the interest rate believed by central bankers to be optimal, in that it is enough to motivate people to spend today rather than defer purchases, as they might do if deflation set in, and it also means debtors’ debt burdens grow lighter in “real,” inflation-adjusted terms, giving them room to take on new debt.
It turns out that flooding the sovereign bond market, as the ECB has been doing, hasn’t been enough to do the trick. The reason is that governments are constrained by European rules limiting the size of budget deficits from borrowing and spending more money, which is what would be necessary to overcome unemployment, put upward pressure on wages, and ultimately generate some consumer price inflation. APP has successfully caused sovereign bond interest rates to fall to very low levels, but that hasn’t resulted in governments borrowing more.
Interest rates on corporate bonds have already been dropping ever since the ECB’s announcement of CSPP in March. By buying lots of bonds from big European corporations, and thereby causing interest rates on corporate bonds to drop, the ECB appears to hope those corporations will be tempted to issue more bonds – i.e. to raise more money – and then invest it in new projects.
Overcapacity
It’s not at all clear it’ll work. Creditworthy corporations can already raise money quite cheaply to finance new investment in plant or equipment. What’s missing is a good reason to do so. Many existing factories are producing well below their capacity, because consumer demand is below the potential production level. In economic jargon, there is a “shortage of aggregate demand.” People aren’t spending enough on consumption to justify a boom in investment in new production capacity.
The ECB also appears to hope that some of those who sell bonds to it via CSPP will use the money from the sale to buy consumer or investment goods, rather than merely buy other financial papers from secondary financial markets – since the latter does nothing for the real economy.
In a May 23 interview with Portuguese newspaper “Publico,” Peter Praet, a member of the ECB’s executive board, said: “Think about portfolio rebalancing: when we buy bonds, the sellers, which are not necessarily banks, get liquidity. What do they do with the cash? Some people spend it, others reinvest.”
But this is a rather optimistic point. Most sellers are institutional investors like banks or pension funds, not households or consumers, and institutional investors generally reinvest in existing financial assets, not in new projects.
If there’s to be a boom in aggregate demand, someone has to step up and start spending a great deal of fresh money on new real-economy projects. It’s not clear anyone other than national governments or the European Union have the financial heft necessary to restoke demand and unleash a new growth cycle.
Fiscal policy and structural reform
The problem is that monetary policy cannot cure what ails the European economy alone. The ECB’s mandate is price stability, not economic reform or fiscal spending – it doesn’t have the mandate or the tools for those things, but they’re really what is needed, as Praet admitted.
“Monetary policy can’t do it alone,” he told “Publico.” “We have always said that we need a comprehensive policy response. We need structural, fiscal and monetary policies.” The ECB, he implied, it doing what it can with the tools and mandate at its disposal – and the minutes from the April ECB meeting suggested it’s high time for increased fiscal spending and more serious structural reform efforts to be added to Europe’s economic policy mix, in order for high unemployment to come down and aggregate demand to go up.
But as long as Europe is committed to austerity doctrines, and being pushed by influential finance ministers to “consolidate” public budgets – i.e. to spend less, rather than more – one crucial leg of the economic policy tripod will remain weak.
