Euro QE: Halfway to Clever, or Halfway to Crazy?

The biggest controversy about quantitative easing, which will soon have been tried in all the world’s major advanced economies, is no longer about the policy itself. It’s about where QE might lead.

Quantitative easing has a deservedly mediocre reputation. When it arrived in the United States and Britain in 2008-2009, QE was promoted as a cure for overly low inflation, while the right wing demonized it as a throwback to overly high inflation. It turned to be nothing of either sort. Some people claim that inflation would have been lower without QE, but the evidence is sketchy. What’s clear is that QE came and went and inflation is still low.

In Japan and now Europe it’s a somewhat different story, as QE has made a clear difference: by devaluing the currency. The yen has lost a third of its value against the dollar since the fall of 2012 when Shinzo Abe began signaling he would push for QE. The euro has lost a tenth of its value against the dollar since the December 4 presser where Mario Draghi made clear QE was on the way.

These currency devaluations will somewhat boost Japan's and Europe's reported inflation rates, but that's an empty victory. As Paul Krugman explained back in 2010, QE was meant to encourage borrowing and spending by raising inflation and thus driving down real interest rates. But that logic doesn't apply to devaluation-driven inflation.

In the real world, borrowers don't actually care about real interest rates. They care how the nominal interest rate compares to their estimation of their future nominal income. Real interest rates, combined with real growth rates, are just a shortcut way of estimating how such calculations work out for the average potential borrower. It usually works because one person's higher prices paid are another person's higher income earned.

But with devaluation-driven inflation, the people earning the higher incomes are outside the country, and not actually earning more in their own currency. None of that is good in any way, shape or form for the importing country. Increases in prices of imported goods are a sheer loss. They make people poorer and reduce spending on domestic products.

The benefit from devaluation comes not from lower real rates, but from increased export competitiveness and increased investment in export-oriented industries. I won't get into the debate over how well that works in the long run. What matters here is that Japan and Europe think it will work.

However much European and Japanese officials protest that they don’t mean to be fighting a “currency war,” they appear to know exactly what they’re doing. Both Japan and Europe have long histories of deliberately devaluing their currencies to boost competitiveness. They can hardly claim not to be familiar with how it’s done.

Matteo Renzi, the Italian prime minister, plainly admitted in a recent interview his reason for supporting QE: His “dream is parity” between the euro and dollar, or basically to double the devaluation of the euro versus what we’ve seen in the past eight weeks. Gary Cohn, the chief operating officer of Goldman Sachs and not usually a big fan of hyperbole, said recently at a Davos forum: “We are in currency wars.”

Anyway, it’s hard to argue with a chart of the euro’s value against the yen. Especially with one as tastefully illustrated as this:

QE’s role as a weapon of currency war is the main news story of the week, but it's not my main reason for writing. The 2010s currency war could even turn out to be a minor footnote in the history of 21st century monetary and fiscal policy, if QE leads where it looks like it might be leading.

Increasingly, QE is being promoted as half of a policy that would combine it with fiscal stimulus, or what Oxford professor Simon Wren-Lewis, borrowing a term from Ben Bernanke who borrowed it from Milton Friedman, calls “helicopter money.” Or for another example, here’s Italian and Australian academics Biagio Bossone and Richard Wood arguing that QE is pointless unless combined with fiscal expansion, in what they term “Overt Monetary Financing.”

Mainstream commentators aren’t so explicit, but many of them favor the same thing, albeit probably on a more moderate scale. Gavyn Davies, a British centrist, called European QE “genuine progress” but “no panacea” and concluded: “The politicians now have work to do on the fiscal and structural components” – by which he means a combination of fiscal loosening and market reforms. Paul Krugman’s well-known preferences for fiscal expansion were understood when he concluded his blog on the European QE announcement by writing: “Great work, Mr. Draghi, but it’s going to take a lot more than this to save the day.”

Similar calls for QE to be joined with fiscal stimulus have been made many times before, but they gained no political traction in the United States or Britain and little in Japan. The idea also faces plenty of resistance in Europe, especially from Germany, which would have to participate in fiscal expansion for it to happen on any scale.

Given the heinous extent of unemployment in southern Europe, the Germans just might be cajoled into going along. And if such a policy is implemented and appears to work in Europe, it might well spread across the developed world. Europe’s decision to launch QE could turn out to be a first step in something very important indeed.

The question is, is QE half-way towards an effective cure for advanced economies’ recent growth malaise? Or is QE half-way towards treating malaise with mad malpractice? It’s time to dust off the old controversies around QE, because this time it might get serious.

Why QE Could Be Halfway to Clever

Whether explicit or tacit, a combination of QE and fiscal stimulus amounts to the same thing: printing money to finance a bigger public deficit. This proposal will sound frightening to many people, and I’ll come back to why such fears might be justified.

But for now, let's focus on two points. First, the taboo aganst printing money to fund public spending has actually already been broken. Since long before QE, European countries have funded their deficits largely by selling bonds to banks which then post those bonds as collateral for central bank credit. That's actually how Greece got into so much trouble. The other members of the Euro Area let Greece get away with a whole lot of that for a long time and then suddenly clamped down.

Regardless of whether it's combined with fiscal expansion, QE means printing money to fund public spending. The central bank prints money and lends it to government, simple as that. But QE without fiscal expansion doesn't fund any more public spending than was already happening, so it doesn't cause inflation.

And the second point: why do we need to be paralyzed by the fear of inflation? Inflation in advanced economies is comfortably low. It's substantially lower than Americans and Europeans were accustomed to until 2008, and much lower than the Japanese considered normal until the 1990s.

Personally, I'm not much convinced by the argument that boosting inflation would significantly encourage borrowing and spending. Until investors and consumers see more income growth, marginally cheaper money will not be much of an enticement. I'm also not at all afraid of mild deflation. That's a topic for another day.

But I do agree that boosting spending would help to employ the unemployed. And if it wouldn't cost much in terms of extra inflation, then why not help them?

The drop in inflation rates in recent years owes to a mix of factors, especially slowing population growth, aging populations, growing preference for leisure, a slowdown in the growth rate of productivity and high unemployment. Only the last of those is likely to respond to helicopter money.

Thus, we could afford to create some additional inflation pressure by printing money and making sure it gets spent. And the one way to be sure printed money gets spent is to have the government spend it. If you’re on the political left, you’d probably like to see more public spending on education, health care, infrastructure, research or even industrial policy.

Personally I think a large part of our problem since 2008 is that advanced economies are increasingly slow to adjust and re-absorb large numbers of laid-off people, because their employment process is increasingly about long-term teambuilding and decreasingly about tapping pools of general laborers. I'd like to see sit-at-home long-term safety nets replaced with public retraining and job placement, which wouldn't be cheap.

But helicopter money doesn’t have to be a license to veer left. If you’re on the political right, reducing taxes is presumably one of your top goals. Helicopter money can also do that, by printing money to substitute for reduced tax collection. There’s no firm guarantee that people would spend their resulting bigger net incomes, but it’s an excellent bet that they would.

The point is, how helicopter money is utilized can be decided democratically. The decision to use it wouldn’t limit people from freely determining the appropriate level of public spending relative to GDP, except by ruling out a regime with less public spending than QE. The Euro Area’s QE program is just over 7% of GDP and public spending is somewhere in the 40s, so that limit seems unlikely to matter.

Another technical point worth making is that funding public spending with QE incurs no direct interest costs. Although the government formally pays interest to borrow from the central bank, the central bank turns around and remits that money right back to government. QE does cost the public if the central bank pays interest on cash deposits, but usually such rates are near zero during QE. In the Euro Area they're currently negative 0.2%, which means the public earns a little money by taxing banks that hold cash.

The bottom line is we'll never know if helicopter money would work unless we give it a try. If inflation accelerates quickly, we might end up having wasted a lot of policy-making effort on a flash in the pan. But there shouldn’t be any other damage done, so long as the central bank can be trusted to respond quickly by reducing or canceling QE. Moderate proponents of combining QE with fiscal expansion want QE to be limited to whatever amount keeps inflation near 2%. Radical proponents want to allow inflation to go up as high as 4%.

In the grand scheme of things, is even 4% inflation really a disaster? Would that be such a terrible price to pay if it would help put substantial numbers of people back to work? Is there some reason why we can’t even allow ourselves to try?

Why QE Could Be Halfway to Crazy

The critiques of helicopter money come mainly from the right, and especially from the Austrian school of economics, a libertarian ideology that’s viscerally opposed to the very concept of central banking. The Austrian school enjoyed a resurgence of popularity in the wake of the 2008-2009 crisis due to its focus on credit excesses, which led many Austrian theorists to predict the American subprime disaster. “Austrians” are generally also goldbugs, so it's no surprise they called the post-crisis surge in gold prices.

Since then the Austrians – actually mostly American these days – have lost a lot of credibility by repeatedly making extreme doomsday predictions about QE and inflation, or even hyperinflation. But if one looks past the often nutty types that Austrian theory tends to attract and actually read the Austrian economists, they do make a very important point.

The Austrian school’s aversion to central bank money-printing actually goes back to a 1912 book by Austrian economist Ludwig von Mises, Theorie des Geldes und der Umlaufsmittel, later translated into English as The Theory of Money and Credit.

The book delivered a dire warning about the threat posed specifically by printing money to fund public spending. Few listened, and nine years later, Germany was crushed by hyperinflation. German democracy was mortally wounded.

There have been many more episodes of hyperinflation around the world since the 1920s, and all of them have had one thing in common: money-printing was used to fund ever more fiscal expansion.

I’m not trying to suggest that Europe or any other contemporary advanced economy would be so irresponsible as to print money to the point of hyperinflation. Hyperinflation is a deliberate, desperate policy that usually reflects some very serious underlying problem, such as war or a collapse of the state’s ability to collect taxes. A government that’s adding zeroes to its bills to fund itself is a government that’s not looking much past tomorrow.

My point of going through all this is that, unlike QE alone, QE in combination with fiscal expansion can be extremely powerful. Even devastatingly powerful. It’s not a policy you would want a blithe, happy-go-lucky type to manage on your behalf. There needs to be a very high level of trust between society and the central bank for it to work.

What if, for example, helicopter money is tried and the result is mediocre: unemployment comes down some, but inflation also rises quickly, to say 5%. Would central bankers have the political will to cut off the QE tap, when politicians might well be clamoring for more QE, in order to bring down unemployment more quickly?

There are any number of other possible reasons for caution. QE could make it too easy for governments to raise funds and thus remove the usual disciplining role that bond markets play. In other words QE might be an enabler for bad governance.

There are growing numbers of people who think that QE or low interest rates actually reduce growth. Personally I find the economic models that attempt to explain how that might work to be a bunch of hoo-ha (you can Google John Cochrane and Stephen Williamson and judge for yourself). But perhaps in a few protected industries with stifled competition there could be a similar lack of market discipline that's being exacerbated by overly cheap money.

Another thing that should give everyone pause is that managing the money supply is simply mysterious. Until QE was tried, every mainstream economics school predicted it would spur inflation, as did all but a few mainstream economists (Krugman was one who got it right early – and no, the rest of you guys, he will never let you live that down).

To this day, economics students are learning models in which the money supply and consumer prices are presumed to even out over the long run, even though our experience with QE has disproved that. Economics students are still learning that there is an attribute of money called “velocity,” which supposedly determines the relationship between money supply and spending, even though for the last six years US money supply and spending have moved completely independently of each other.

The concept of “velocity” is so prevalent that even I have used it in my professional writing, because it’s by far the most easily understood way to explain how a developing economy can boost money supply without causing inflation (by simultaneously reducing “velocity”). But the concept of velocity misses the whole point. The crucially important thing that changes over time and differs across countries is the willingness of people to hold their savings in the form of money.

In advanced economies, people turn out to be willing to hold quite a lot of their domestic currencies as savings. The Chinese turn out to be willing to hold even more, albeit with some coercion. Among other emerging markets and developing countries, the situation varies widely from country to country. Some situations are easy to predict, such as Venezuelans' growing aversion to the bolivar. Others come out of the blue, such as Myanmar's escape from chronic double-digit inflation, which began with a lucky pause during the 2009 global collapse in food prices and then all just sort of fell together from there.

The main thing I discern from my experience with various countries is that changes in people’s willingness to hold money savings are self-propelling. When a country with chronic high inflation starts to improve, savings pour into bank deposits, strongly suppressing inflation and building trust in the currency. That draws in more savings into banks, and the process continues.

Or the spiral can go the other way. When people start to expect high inflation, and especially inflation that exceeds interest rates on savings deposits, they pull their savings out of the bank and rush to buy property or a business or gold. Or they just consume more of their income. That leads to higher inflation, and the process continues.

Which, by the way, is exactly how helicopter money is meant to work. And begs the question, will people really understand and react in time before it goes too far?

Again, the simple, almost too simple answer is that the central bank will set an inflation target, and stop QE when that target is surpassed. But would QE be stopped in time before that spiraling change in mentality sets in? Is a 4% inflation target low enough to avoid the spiral? Or, as Ben Bernanke argued back in 2010, would it be crucial to maintain a 2% target, in order to preserve hard-won confidence in central banks?

Those are the trillion-dollar questions. If you can answer them, you can say whether QE is halfway to clever or halfway to crazy. I honestly don’t know.