If QE, What QE?

Riddle 01: Euro-crisis: If QE, what QE?

December, 2014

Markus K. Brunnermeier

Max and Moritz

Max makes the following claim to Moritz: “If the ECB ever were to buy government bonds in the context of a quantitative easing program, then it should primarily purchase German government bonds.”

Moritz thought that Max suggest this because the ECB should buy safe (default free) assets since it is not the task of a central bank to assume credit risk. Max replied that his reasoning is different.

Now Moritz looks perplexed as he initially thought government bonds should be bought according to the ECB key across all euro area countries. Max explains his reasoning to Moritz:

consumer_price_index - Europe

From the inception of the Euro until the Euro crisis, the inflation rate in peripheral countries persistently exceeded German inflation rate. A gap in the price level emerged that undermined the competitiveness of peripheral countries. (see figure)

The price level starting at normalized level of 1000 in 1999 rose in Greece for example from 100 to over 150, in Spain to almost 140 while in Germany it never reached 130. To narrow this price level gap and to restore competitiveness of peripheral countries, German inflation has to be higher than the peripheral one. Hence, to push the German inflation rate one has to increase the money supply especially in Germany. Consequently, if the ECB ever were to undertook QE it should purchase German bonds.

Moritz initially thought that Max would make a different case and simply mention that the ECB should buy German bonds because they have the lowest default risk. Moritz is perplexed and now asks you for your opinion. How do you judge Max’s reasoning depending on whether your thinking is guided by

a)      Monetarism,
b)      (New) Keynesiansm,
c)      The Fiscal Theory of Price Level,
d)      The I Theory of Money?