QE by the ECB.

The United States, Britain, and Japan all eventually responded to the “Great Recession” with “Quantitative Easing”—central bank purchases of public and private bonds in order to pump money into the economy.[1] Europe resisted this policy[2] and its economic recovery has trailed most other places. The ECB’s goal has been to see an annual inflation rate of 2 percent. It hasn’t worked. In December 2014 the inflation rate hit minus 0.2 percent. Economists feared that Europe would descend into a deflationary spiral. Therefore, on 22 January 2015, the European Central Bank (ECB) announced an initiative to buy 60 billion Euros worth of public and private bonds every month :until we see a sustained adjustment in the path of inflation.”[3]

Will the ECB action be sufficient to propel the European Community on the road to a solid recovery? When combined with the unanticipated fall in world oil prices and a depreciation in the exchange value of the Euro, Quantitative Easing might get the European economy moving. Still, there is a great deal of uncertainty going forward.

At the same time that he announced the program of bond-buying, ECB chief Mario Draghi urged the need for “structural reforms” to create the basis for the “confidence” among investors that is needed to encourage investment.[4] Will European governments be willing to implement such reforms after resisting them for so many years in crisis conditions? Or will they hope that QE can provide enough stimulus to allow them to ignore unpleasant choices? Jens Weidmann, president of the German central bank, worried in public that this might be the case.

How will the ECB initiative affect exchange rates between the Euro and other currencies? The dollar has been rising against the euro and gained another 2 percent after the ECB policy announcement; the Swiss ended their “peg” of the franc against the Euro and the franc rose 17 percent in value in one day. The change in exchange rates will make Euro-zone goods more competitive in foreign markets, but they will make Swiss and American goods less competitive in those same markets. Countries that borrowed in dollars will find it more difficult to repay those loans now that the value of the dollar is rising. In short, it creates a drag on the world economy at a critical time for the recovery.

One thing that now seems impossible to foretell is the effect of important central banks creating so much liquidity. Will it affect the basic stability of the world economy over time? No one is talking about this problem at the moment. They have more pressing business at hand.

[1] In the United States, “QE” pushed up asset prices like those for stocks and homes. This had the unintended effect of adding to the sense of an unequal sharing of the economic recovery.

[2] In large part the resistance stems from people in the northern “creditor” countries who feel that they “were had” by the Greeks and fear that southern “debtor” counties may try to stick them with the real costs of the bail-outs. This feeling comes on top of a long-standing belief that weaker economies suffer from the self-inflicted wounds of overly generous welfare states and a hostility to business.  The complicated governing system for a central bank serving nineteen sovereign states, each with their own central bank, allowed the “creditor” countries to hold the “debtor” countries at bay for years.  Both the emotional and the institutional components to economic policy-making seem incomprehensible to some leading American academic economists.

[3] Neil Irwin, “Fear That Eurozone Stimulus May Be Too Little or Too Late,” NYT, 23 January 2015.

[4] German Chancellor Angela Merkel immediately emphasized this point to the Italians. Dutch prime minister Mark Rutte then piled-on to the same effect. See: Jack Ewing, “Compromise and Persuasion Won Grudging Support for Bond Buying,” NYT, 24 January 2015.

Signals from the Depths.

Democratically-elected governments have been responding to the “Great Recession” by trying to cut public spending.[1] This is a throw-back to the initial—and disastrous—response to the “Great Depression” after 1929. It is a rejection of the subsequent Keynesian deficit-spending policies that eventually got countries out of the Depression. The “sequester” in place of more stimulus has dragged on American economic recovery since 2011; the Germans insist upon austerity in the European Union, and Japan’s parliament recently passed a higher consumption tax that short-circuited an attempt to stimulate growth there.

In the absence of spending programs, central banks have used, are using, or may be about to use purchases of long-term debt (called “quantitative easing”) to pump money into the economy. This is better than nothing.[2] The Federal Reserve Bank has just ended its buying of long-term bonds and has hinted at higher interest rates in 2015. Thus, it is signaling its belief that economic recovery is well underway in the United States.

Still, amidst all the talk about an improving American economy, there have been signs of new troubles ahead in the world economy.[3] By early October 2014, world prices for bonds, currency, and commodities were being read to suggest the possibility of a new global slowdown. It isn’t clear that there are any policy tools that could check this descent.

Economic growth should reduce un-employment. Over time, lower unemployment should lead to a rise in wages and to higher prices. However, all the major advanced economies seem headed toward low long-term interest rates. There appears to be a widely-shared belief among knowledgeable people that inflation is not going to fire up any time soon. Why would people believe this?

First, the value of the dollar has been rising against the currencies of Europe, Japan, South Korea, and Japan. You could read this as investors taking flight from those currencies to the security of currently stable dollars. This may reflect a belief that by investors that the world economy is headed downhill and that there aren’t any policy tools to control the descent.

Second, stocks and bonds usually move in opposite directions. In an expanding economy, money will flow toward stocks as investors try to share in profits and rising share prices. In a shrinking economy, money will flow to bonds as people try to avoid being stuck with stocks whose price is falling. Monetary policy usually seeks to keep interest rates low when the economy needs to be propped-up. Until that is shown to be working, investors will accept even low yields from bonds. The interest rate on 10-Year US bonds has fallen over the course of the year from 3.0 percent to 2.2 percent. Purchasers are bidding-down the interest on these bonds out of their eagerness to have them in their portfolio.

Third, the price of commodities has been falling. The price of crude oil is down 22 percent since the end of June. The price of corn futures has fallen by 31 percent since late April. Abundant production is forcing down prices. It comes at an awkward time for confidence in the world economy.

What do you do when unelected experts and private investors disagree with elected representatives on the best policy? What if the experts and investors are right?

[1] Neil Irwin, “What the Bank of Japan’s Surprise Move Means for the Global Economy,” NYT, 31 October 2014.

[2] Moreover, it pushes up the prices of assets, which are owned by upper income groups, better than it stimulates employment or raises wages. So, many voters find themselves preoccupied by inequality.

[3] Neil Irwin, “The Depressing Signals the Markets Are Sending About the Global Economy,” NYT, 15 October 2014.