Barry Eichengreen writes: The European Central Bank is moving, hesitantly but ineluctably, toward quantitative easing. The threat of deflation – and the ineffectiveness of its previous measures – leaves it no choice. The question is whether the ECB will be able to move quickly enough.
The ECB has already attempted to ease credit conditions by purchasing high-quality asset-backed securities. It has bought securities backed by cash flows from private-sector mortgages, so-called covered bonds, and it has floated the idea of buying corporate bonds and multilateral securities issued by the European Investment Bank.
But it is clear that this will not be enough. ECB President Draghi will need to continue working to build a consensus within the bank’s governing board for purchases of government bonds.
But Draghi and his colleagues will proceed in small steps, given fears in Germany that quantitative easing is just another name for runaway inflation. Initially, the ECB will buy a small volume of government bonds; when this fails to produce economic Armageddon, it will begin to scale up its purchases.
When deflationary expectations are entrenched, consumers and investors delay spending on the ground that prices and costs will be lower tomorrow. Less spending means even less inflation and, in the worst case, falling prices.
Opponents of quantitative easing worry that it augurs inflation. The most influential objection to quantitative easing is that it will relieve the pressure on European governments to reform. According to this moral-hazard argument, the authorities will push ahead with painful labor- and product-market reforms and pursue the fiscal consolidation needed to gain the confidence of investors only if they remain under the gun. If the ECB purchases their bonds, governments will be able to ignore market pressure.
Under current conditions, with the inflation rate dangerously close to zero, governments are reluctant to do anything that increases the risk of deflation. And structural reform and fiscal consolidation are both deflationary in the short run.
Structural reform that increases the flexibility of labor and product markets is deflationary as well. Enhancing wage flexibility in an environment in which unemployment exceeds 11% will allow firms to cut wages, and lower labor costs will permit them to cut prices in an effort to gain market share. Deregulation that intensifies product-market competition will similarly lead to lower prices (that being what competition does).
Perhaps the best thing the ECB could do to encourage fiscal consolidation and structural reform is to banish the specter of deflation. Only full-bore quantitative easing can do that.
