Tue, Feb 03, 2015 - Page 9 News List

The eurozone cannot rely only on quantitative easing

Different conditions in the EU mean that the program will not have the breadth of effect that it did in the US

By Martin Feldstein

Illustration: YUSHA

Although the European Central Bank (ECB) has launched a larger-than-expected program of quantitative easing (QE), even its advocates fear that it might not be enough to boost real incomes, reduce unemployment and lower governments’ debt-to-GDP ratios. They are right to be afraid.

However, first the good news: anticipation of QE has already accelerated the decline of the euro’s international value. The weaker euro will stimulate eurozone nations’ exports — roughly half of which go to external markets — and thus will raise the eurozone’s GDP. The euro’s depreciation will also raise import prices and therefore the overall rate of inflation, moving the eurozone further away from deflation.

Unfortunately, that might not be enough. The success of QE in the US reflected initial conditions that were very different from those of Europe at the moment. Indeed, eurozone nations should not relax their reform efforts on the assumption that ECB bond purchases will solve their problems. However, even if these nations cannot overcome the political barriers to implementing structural changes to labor and product markets that could improve productivity and competitiveness, they can enact policies that can increase aggregate demand.

To be sure, the major eurozone nations’ large national debts preclude using traditional Keynesian policies — increased spending or reduced taxes — to raise demand through increased budget deficits. However, eurozone governments can change the structure of taxes in ways that stimulate private spending without reducing net revenue or increasing fiscal deficits.

First, though, consider why QE’s ability to stimulate growth and employment in the US does not imply that it will succeed in the eurozone. QE’s effect on demand in the US reflected the financial-market conditions that prevailed when the US Federal Reserve began its large-scale asset purchases in 2008. At that time, the interest rate on 10-year Treasury bonds was close to 4 percent. The Fed’s aggressive program of bond-buying and its commitment to keep short-term interest rates low for a prolonged period drove the long-term rate down to about 1.5 percent.

The sharp fall in long-term rates induced investors to buy equities, driving up share prices. Low mortgage interest rates also spurred a recovery in house prices. In 2013, the broad Standard and Poor’s index of equity prices rose by 30 percent. The combination of higher equity and house prices raised households’ net worth in 2013 by US$10 trillion, equivalent to about 60 percent of GDP for that year.

That in turn led to a rise in consumer spending, prompting businesses to increase production and hiring, which meant more incomes and therefore even more consumer spending. As a result, real (inflation-adjusted) GDP growth accelerated to 4 percent in the second half of 2013. After a weather-related pause in the first quarter of last year, GDP continued to grow at an annual rate of more than 4 percent.

Thus, QE’s success in the US reflected the Fed’s ability to drive down long-term interest rates. In contrast, long-term interest rates in the eurozone are already extremely low, with ten-year bond rates at about 50 basis points in Germany and France and only 150 basis points in Italy and Spain.

So the key mechanism that worked in the US will not work in the eurozone. Driving down the euro’s US dollar exchange rate from its US$1.15 level — where it was before the adoption of QE — to parity or even lower will help, but it probably will not be enough.

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