In June 2012, the balance sheet of the ECB peaked at over €3 trillion. Since then it fell every month, so that by the end of 2013 it stood at €2.2 trillion. Over this same period, the Federal Reserve’s balance sheet rose from less than $3 trillion to more than $4 trillion. That is, as the ECB’s balance sheet was falling by a quarter, the Fed’s rose by a third!
One of the most important reasons for this difference is that the two biggest central banks have very different operating procedures. And, as a result, their balance sheets have very different structures. At its peak, of the €3+ trillion worth of assets on its balance sheet, the “Consolidated financial statement of the Eurosystem” showed more than €1.2 trillion related to refinancing operations. These are repurchase agreements with the commercial banks of the euro area. By comparison, over 90 percent of the Fed’s balance sheet is in the category labelled “Securities held outright.”
Since European commercial banks decide whether to tender securities in a refinancing operation, which have been offered in unlimited volume since October 2008, they collectively determine the size of the ECB’s balance sheet. And, the fact that these banks want to shed reserves is what’s behind the shrinkage over the past 18 months. By contrast, the Fed can purchase securities and force US banks to hold reserves. This balance sheet expansion, what is commonly known as “quantitative easing,” has been a foundation of the Fed’s expansionary monetary policy for more than five years now.
The lesson is that, because of the way it interacts with the financial system, the ECB cannot engage in quantitative easing as it is commonly understood. Unless it were massive, an increase in outright purchases of bonds would simply change the size of the refinancing operation, leaving the level of reserves in the banking system unchanged. And by massive, I mean big enough to replace virtually all of the reserves currently provided through the refinancing operation, which at the end of 2013 was nearly €700 billion.
Another serious constraint on massive ECB purchases is that there exists no default-free asset in the euro area. The Fed can – and does – purchase large volumes of U.S. Treasuries and government-backed mortgage securities. The ECB has no such option. Were it to purchase only the lowest-risk government debt in the euro area, it could exacerbate the strains on those governments (and banks) already facing a funding challenge. If, instead, it chose to build up large positions in the stressed debt of these governments, it would create a politically sensitive level of default risk and undermine the market discipline that promotes fiscal rectitude.
What can the ECB do to further monetary accommodation when its policy interest rate is at zero? The answer is that they still have several tools available. These include altering the mix of assets on their balance sheet in an effort to change relative interest rates, forward guidance to influence medium- and long-term interest rates, and even charging rather than paying commercial banks for their reserve deposits at the ECB (setting a negative rate on the deposit facility). In the extreme, if outright deflation were to set in, the ECB also could cap the euro versus the dollar in order to import U.S. inflation expectations.