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Judging by the policy advice being offered to the European Central Bank by the International Monetary Fund and the editorial writers of the Financial Times, one would think that there was an unambiguous case for ECB quantitative easing. After all, European inflation is presently running at around a quarter of the ECB’s close to but below its 2% inflation target and the specter of deflation is now haunting the continent. However, before rushing to embrace external advice “ to do whatever it takes” to meet its inflation target, the ECB might want to reflect on a number of considerations that raise questions as to whether quantitative easing at this juncture is the unalloyed panacea its supporters claim it to be.
The first consideration is that European and global asset prices have already become largely disconnected from underlying economic fundamentals as a result of the unprecedented expansion of the Federal Reserve and the Bank of Japan’s balance sheets. Indeed, despite substantial increases in public debt to GDP ratios and the clearest of signs of austerity fatigue, European sovereign bond yields have now declined to around pre-crisis levels. Meanwhile, the Italian and Spanish governments now borrow at similar rates as does the US government despite the fact that their public debt situations appear to be very much less sustainable than that of the United States.
One would think that large scale quantitative easing by the ECB at this stage would run the risk of further inflating both European and global asset bubbles in much the same way as the Federal Reserve and the Bank of Japan’s rounds of quantitative easing have done beforehand. That would carry with it the distinct risk of a very hard global and European economic landing once interest rates start to be normalized. It would also imply that any benefit to short-run economic growth to be obtained from quantitative easing might be more than offset by the impact of an asset price bust further down the road on longer-term economic growth.
A further consideration that the ECB might want to ponder is how effective quantitative easing is likely to be now in lifting European economic growth. With long-term European interest rates already at very low levels, one would think that there is relatively little mileage to be obtained from a further reduction in European interest rates. Where there might be mileage from quantitative easing would be a substantial cheapening in the value of the Euro. However such a course of action would run the risk of reigniting charges of a global currency war especially considering Europe’s lack of any balance of payments need for a cheaper currency.
Before opting for a policy of quantitative easing that might at best raise short-term growth prospects at the cost of heightening the probability of a hard European economic landing further down the road, European policymakers might want to weigh alternate policy options. They might for instance wish to consider supporting the ECB’s monetary policy by more expansionary fiscal policies for those countries like Germany that have the fiscal room to do so. They also might consider policies aimed at increasing the flow of credit and at reducing borrowing costs for small and medium-sized firms in the European periphery, which is most in need of a boost to its short-term economic growth prospects.
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