By allowing the European Central Bank (ECB) to start buying debt issued by its member states, the eurozone is copying a strategy now associated with the earlier return to growth in the US and UK.
Quantitative easing (QE) may not have worked in the way its architects hoped; reviving private investment by reducing borrowing costs and raising asset values. But QE has set up conditions for such revival by helping governments and households finance their debt at low cost, so that spending picks up and gives an incentive to invest.
There will be a further boost if QE weakens the euro against other currencies, lifting the eurozone’s exports and re-introducing inflation (which further reduces the real costs of debt).
Back to the future
QE takes the eurozone back to the future. Until 2008, it suffered from what is now viewed as an excess of internationalism. Newer members that had traditionally borrowed at a premium (Greece, Spain, Portugal and Ireland) could now get credit as cheap as Germany’s. Although they were meant to aspire to German-style rectitude, this was a temptation to fiscal (and sometimes private-sector) recklessness. Their private and government debts built up to levels that were unsustainable, once growth rates slowed and interest rates rose.
After 2008, the zone abruptly “renationalised”. Less dynamic countries were again left paying substantially more for their debt, which further drained their dynamism. Capital no longer flowed to them, despite these higher yields. More indebted governments were forced into budget cuts that stalled growth, reduced real income and eroded tax revenue, leaving their finances in deficit and worsening downturns, which began to strain social cohesion.
To break this vicious circle which risks forcing Greece’s exit (and a default on euro debts that would hurt the zone’s already fragile banks) the ECB will now attempt to re-internationalise its monetary system.
As in the Anglo-American approach, it won’t directly buy member states’ new government debt. This will reassure the less heavily borrowed member states (especially Germany) that they’re not taking responsibility for debts caused by other countries’ excesses. But by paying banks and other private investors for existing debt, the ECB will give them newly created funds that might then finance more affordable lending and increased production.
Not a lifeline
Despite the hopes now invested in it, QE is unlikely to ensure the survival of the eurozone’s peripheral members. Experience suggests that without complementary fiscal policy action, the effects of these measures will be limited. Governments must be able to use their new borrowing opportunity to restore (through fiscal deficits) the aggregate demand that private investment and consumption are currently not generating.
EU rules prevent this, imposing an “excessive deficit procedure” on any government whose deficit exceeds 3% of its national income (GDP). For comparison, the US overcame its post-2008 downturn with a deficit deliberately widened to almost 10% of GDP, and the UK’s recovery still requires a deficit of close to 6%.
The EU deficit limits reflect monetarist economists’ longstanding beliefs that government borrowing will undermine longer term growth (by substituting public consumption for private investment), and cause longer term inflation (through the increase in money supply due to new borrowing). Neither of these beliefs has fared well in the years since 2008, as the American approach has featured fiscal deficits alongside reviving private investment, and QE alongside motionless inflation.
Efforts to give the ECB comparable powers to other big central banks such as the US Federal Reserve and Bank of Japan – including authority for QE and zone-wide bank supervision – move Europe further away from the approach that enabled its post-war revival.
Disowning the past
The EU took shape in the Bretton Woods era, when national governments left themselves scope to choose their own economic and social policies, by closing off their capital markets. This enabled them to run fiscal deficits when the domestic economy grew too slowly, without being punished by the bond market when their domestic interest rates moved out of line.
It also preserved the benefits of a stable (though not rigidly fixed) currency, which underpinned the post-war growth of international trade. The European economy was it its most dynamic under this framework, which was effective from around 1950-71.
Bretton Woods is long gone, and its international capital curbs might be impossible to recreate after a half-century of financial deregulation and innovation. But the EU’s success in that era – when it rebuilt shattered nation states and restored war-torn economies to US-style prosperity – stands in informative contrast to its malaise in the decades before and after economic and monetary union.
The EU originally worked – as historian Alan Milward persuasively recounted by giving up selected aspects of national sovereignty in order to reinforce what remained. It was a project to rescue the nation state, not to transcend it.
The monetary union has worked less well because it weakened some aspects of national sovereignty – fiscal policy discretion, and the accompanying leeway over taxation and welfare arrangements – without which economic growth and social cohesion can be lastingly compromised. Further monetary integration, under present fiscal rules, could be another step away from what succeeded in the past.