The U.S. has been imitating Europe for years, boosting government spending and racking up debt, creating a healthcare system that doesn’t work and adding costly new social benefits.
Now it’s Europe’s turn to imitate the U.S. As expected, European Central Bank head Mario Draghi announced a quantitative easing (QE) program for Europe last week.
Does this look like deflation to you?
Over the past six years, the U.S. Federal Reserve Board’s three QE programs boosted the Fed’s balance sheet from less than $1 trillion to $4.48 trillion. In comparison, the ECB’s QE program is modest; the ECB will purchase $1.24 trillion of existing sovereign bonds and debt securities over the next 18 months.
But any QE program would be modest in comparison with the Fed’s. And, long term, maybe the first round of QE doesn’t work, the ECB will continue to imitate the U.S. and follow with additional rounds of bond buying.
The ECB’s action raises a few questions:
If Draghi believes that bond buying is going to help Europe, why hasn’t he tried it before now? The ECB has tried everything but QE, but primarily relied on forward guidance, which amounts to talking about the economy. Forward guidance would be an absurd economic policy anywhere, but in a central bank – but not as absurd as QE. Forward guidance also doesn’t require the purchase of trillions of dollars’ worth of assets.
Will QE have an impact on interest rates if they are already near zero? How much lower can they possibly go? And if interest rates that low have not stimulated spending and investment, what difference will a few basis points make? QE is enacted to lower interest rates, because – in theory, anyway – the lower rates go, the more they will stimulate spending and investment. However, European interest rates are already near zero and the interest rate on bank deposits is negative.
Why is the ECB worried about lower gas prices? The big concern in Europe, as Draghi expressed, is deflation. Deflation can have a catastrophic impact on the economy, as we’ve explained, but it can also have a positive impact by putting more money in consumers’ pockets, which will leave them with more money to spend on other products, which will stimulate the economy much more effectively than QE.
As in the U.S., European’s deflation scare is due primarily to dropping gas prices, according to David Stockman, who wrote, “Well, of course the CPI (in Europe) has momentarily weakened. Crude oil has experienced a monumental plunge of more than 50% since mid-2014. That has temporarily dragged down the euro zone’s reported CPI and the math isn’t all that complex. During the last 12 months, euro zone energy prices have fallen by 6.3%, and everything else is still 0.6% higher than a year ago.”
Deflation can be dangerous when it causes prices to drop and consumers stop spending, because they’re waiting for prices to continue dropping. But demand for gas is inelastic; consumers won’t stop buying it because prices are dropping.
If low gas prices are bad for the economy, would high gas prices be good for the economy?
Following the logic of the economics wizards that run central banks, the best thing that could happen would be for gas prices to increase. They are probably the only people in the world who are nostalgic about $3+ a gallon gasoline (more in Europe, of course). You may recall that when gas prices were that high, the economy was not booming.
One impact of QE will be to weaken the euro, which should in turn make gas – along with everything else – more expensive for Europeans.
If deflation is a problem, why buy bonds? Why not just print trillions of dollars’ worth of euros and circulate the money throughout the economy? An increase in the money supply should spur inflation by decreasing the value of the currency, since supply increases and demand does not.
For that matter, why not just drop euros out of helicopters all over Europe?
This was Milton Friedman’s tongue-in-cheek solution to deflation (with dollars, instead of Euros, of course). Dropping euros out of helicopters would be more efficient than buying bonds with them – and it would be more popular with the recipients of those euros.
If there are already more bank reserves than banks can handle, how will adding to those reserves stimulate the economy?
As The Wall Street Journal noted, “Bank reserves are already in massive excess. Adding more, as the ECB is expected to do, won’t add growth or stop the price declines because there’s no longer any link from central-bank reserves to private-sector money.”
If QE has failed in other countries, such as the U.S. and Japan, why would it work in Europe (where nothing and no one seems to work)?
The U.S. has struggled through a slow recovery, with the economy growing at a rate of about 2% since the recession ended. Growth began to pick up after quantitative easing ended. A coincidence? Not likely.
The Bank of Japan has bought bonds worth more than 50% of its gross domestic product and there’s been no impact on growth.
Maybe Europe will buck the trend, but there’s no logical reason why it should.
When this round of QE fails, will there be more?
The first rule of politics is that if something doesn’t work, do it again. The U.S. had three rounds of quantitative easing, not including Operation Twist. When 18 months of QE fail to move the growth needle in Europe, you can expect to be reading about QECB2 or maybe Operation Tango.
Will QE provide an excuse for European politicians to not adopt pro-growth policies and let the central bank handle the economy?
In spite of the slow-growth recovery, the U.S. still has the world’s highest corporate tax rate and the U.S. remains an anomaly in taxing corporate profits that are repatriated to the U.S. American businesses also have a mountain of new regulations to deal with, including the Affordable Care Act.
The net result has been that American businesses continue to hire part-time workers and to move their headquarters abroad. The federal government gives them an incentive to do so.
If the economic leader of the free world makes no effort to enact pro-growth policies, socialistic Europe is unlikely to do so. European politicians have enacted “austerity measures,” of course, but in Europe “austerity” means working a 35 hour week and not taking the entire summer off.
Inaction by European politicians is likely to be as effective inaction by U.S. politicians. At least when politicians do nothing, they don’t add to the problem.
So now we have Europe’s Central Bank announcing QE, weakening its currency and chasing the arbitrary 2% inflation target. You’ll know the European transition to The United State of Europe is complete when Mario Draghi announces that former Fed Chair Ben Bernanke has been retained as a consultant to the ECB. Or maybe, when QE doesn’t work, he’ll start talking about macroprudential supervision.