European quantitative easing is no panacea

As Europe’s downward economic and political spiral continues, pressure is mounting on the European Central Bank (ECB) to engage in Federal Reserve-style quantitative easing. While such a move is long overdue, it would be a serious mistake to believe that it would in itself extricate the European economy from its present difficult economic circumstances. Rather, for quantitative easing to succeed in Europe, it would need to be accompanied by a combination of fiscal policy stimulus in those eurozone countries that have the fiscal space to do so and of far-reaching growth promoting structural reform in the European economic periphery.

{mosads}In gauging the likely success of aggressive ECB quantitative easing in Europe, it is important to bear in mind how different the European financial system is from that in the United States. Whereas in the United States around 80 percent of overall lending is intermediated through the securitized credit market, in Europe the bulk of lending is done by banks, with only 20 percent of credit intermediated through the securitized credit market. As such, one must expect that the lower interest rates on corporate bonds that might be expected from quantitative easing would have a very much lesser impact on the European economy than it did on the U.S. economy. By the same token, with much shallower financial markets in Europe than in the United States, one must expect a very much lesser wealth effect in Europe through higher bond and equity prices than was the case in the United States.

There are at least two further reasons to expect that European quantitative easing will not be particularly powerful. The first is that as a result of ample global liquidity, European interest rates are already very low. As a result, there is not much room for European interest rates to fall further. The second reason is that Europe would be engaging in quantitative easing at the very time that the Japanese are very aggressively doing the same thing to weaken the Japanese yen. As a result, while European quantitative easing could be very helpful in cheapening the euro against the U.S. dollar, it is likely that the euro’s depreciation would be fairly limited on an effective basis.

The prospect that quantitative easing in the European context will not be as effective as in the United States is regrettable considering the presently dire straits in which the European economy now finds itself. The European economy has yet to regain its 2008 pre-economic crisis level of activity and it now appears to be on the brink of yet a third economic recession. Equally troubling is the fact that overall European unemployment remains stuck at a stubbornly high level of around 11.5 percent while inflation has now reached a very low level. This has to raise the specter of Europe succumbing to Japanese-style deflation, which is the last thing that its highly indebted economic periphery now needs.

To his credit, in recent months, ECB President Mario Draghi has been alerting European policymakers to the dangers that the European economy now faces, as well as to the limits as to what monetary policy alone can realistically be expected to achieve. He has also been exhorting European policymakers to redouble their efforts at structural reform to promote economic growth, while at the same time urging those European countries with sound public finances to engage in fiscal policy stimulus. One has to hope that the ECB now goes ahead with full-scale quantitative easing without further delay and that European policymakers heed Draghi’s call for fiscal stimulus and structural reform. Since if they do not do so, Europe risks succumbing to Japanese style deflation.

Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.