Illustration by Sam Island
Illustration by Sam Island

The European Central Bank may soon have to roll out the heavy artillery, in the form of an asset purchase program similar to those in the U.S., U.K. and Japan, to fight the specter of deflation. But in a currency union with 18 different sovereign bonds, the tough question will be what to buy.

The best solution: Purchase loans from banks -- what I call euro quantitative easing in bank loans.

Despite substantial progress over the past year, the euro-area economy remains vulnerable. Spare capacity and weak growth, along with relative price cuts by countries trying to restore competitiveness, is putting severe downward pressure on inflation. The transition to a European banking union has been prompting banks to cut back on lending for fear of being required to raise more capital, generating a further disinflationary impulse. Deflation, or even sustained very low inflation throughout the euro area, would raise the burden of debt in inflation-adjusted terms, and make it harder for struggling countries to regain competitiveness and bring down their debts.

If the economic outlook and lending trends don't improve, the ECB will have to consider further monetary stimulus at its next policy-making meeting in early March. Its options include reducing its main refinancing rate to 0.10 percent from the current 0.25 percent, and altering the supply of bank reserves with an eye toward imposing a negative interest rate on deposits at the ECB -- a policy that would encourage putting the money to work rather than parking it at the central bank.

The most powerful way to fight deflation risk, though, is by buying assets, also known as quantitative easing. The challenge is figuring out what kind of quantitative easing would be most effective in the euro area.

Buying sovereign debt should never be ruled out. There are plenty of euro-area government bonds to buy, so purchases could be activated at short notice on a large enough scale to prop up inflation expectations. Still, there are substantive reasons why it's not ideal.

For one, the euro area lacks a common risk-free government asset such as U.S. Treasuries. Rather, it has 18 different sovereign issuers, some of which are relatively risky. The ECB already has the Outright Monetary Transactions program, in which it stands ready to buy the bonds of struggling countries that agree to tough adjustment programs. While not yet activated, this program has reduced borrowing costs for governments such as Spain and Italy. But its legality has been questioned by the German constitutional court.

Buying the bonds of all governments according to the size of countries' economies would put the ECB on firmer legal foundations -- and might be necessary if the ongoing legal battle over Outright Monetary Transactions (now heading to the European Court of Justice) were ever to lead investors to lose confidence in the targeted program. But as long as the ECB is fighting in the courts, it would be problematic to start buying longer-term government bonds without the fiscal conditions that the outright transactions require for purchases of shorter-term bonds.

What's more, buying sovereign bonds might be less effective in the euro area than in the U.S. or U.K. The lack of close substitutes for government debt in investor portfolios would mute the effect on other interest rates. Lowering government borrowing costs wouldn’t directly address the constraints that are preventing banks from lending to businesses and consumers.

As ECB President Mario Draghi has hinted on at least two occasions, the central bank has an alternative: purchases of bank loans packaged into asset-backed securities. This would provide monetary stimulus while alleviating capital and leverage constraints, thereby enabling banks to make new loans. As such, it would be akin to the Federal Reserve's purchases of mortgage-backed securities -- what former Fed Chairman Ben Bernanke called “credit easing,” a form of quantitative easing that takes interest-rate risk out of private hands while also lowering other risk premiums and supporting credit supply.

The ECB could use the asset quality review it is now conducting to make sure the loans weren't marked at inflated values by the banks. To be sure, the ECB would still require some protection from loan defaults. This could be achieved through the process of tranching, which splits securities into pieces with different levels of risk and return. The issuing banks would retain a piece designed to absorb the first losses to defaults. Pieces absorbing further losses could be sold to investors; national governments might be asked to add some partial guarantees.

There would be costs. Even with default protection, the ECB would be influencing credit allocation and might be exposed to losses in some extreme scenarios -- something all central banks seek to avoid. But the uncomfortable reality is that central banks always take on some risk during crises, even when lending against collateral.

The ECB could use its muscle as the new banking regulator to push banks to package more loans for sale as securities, while encouraging investors with the prospect that it would buy the senior tranches if deflation risk escalated. However, it would probably take a number of months for banks to issue enough loan-backed securities for the ECB to make large-scale purchases. In the meantime, the ECB should have a back-up plan to buy the senior interest in loan portfolios directly from banks through simple structures created specifically for this purpose, in case it needs to scale up quickly to fight deflation.

Preferably, the ECB would conduct loan purchases proportionally to the size of countries' economies, or on a pan-euro-area basis, allowing the private sector to submit offers from anywhere in the euro area. However, if the central bank wanted to target certain countries experiencing bigger problems, it could probably get around any legal objection by authorizing national central banks in the euro area to make the loan purchases on their own account.

Whatever the details, the ECB should spell out that quantitative easing in bank loans is its contingency plan, and that it stands ready to act -- ideally underscoring this by promising to buy a moderate amount at a future date to jump-start the market. A clear commitment could have a powerful effect on inflation expectations and help keep deflation at bay.

(Krishna Guha is vice chairman and head of central bank strategy at broker-dealer International Strategy & Investment, and a former member of the management committee of the Federal Reserve Bank of New York.)

To contact the writer of this article: Krishna Guha at KGuha@isigrp.com.

To contact the editor responsible for this article: Mark Whitehouse at 1+212-617-5431 or mwhitehouse1@bloomberg.net.