By Frank Conway
Across the Eurozone, we’re being told that the price of goods and services has been falling. Not a bad thing, especially now as those pesky post-Christmas credit card bills are being slipped our front-door letter boxes. Although I must admit that aside from fuel and my tracker mortgage, I struggle to name anywhere else that ‘deflation’ is actually having any material impact on my wallet.
Falling prices are akin to running a slight temperature in the depth of winter; it’s usually a sign that something is wrong!
Deflation is a sign that an economy is in poor shape. Economists usually panic at first signs but then again, that is what economists do especially well, they panic!
The ECB likes a certain amount of inflation but only when it is less than 2% annually. Which brings us to the current QE debate. No, it’s not the Queen, its Quantitative Easing. Bit of a mouthful that really means printing money.
Quantitative easing is a monetary policy organised by central banks in an effort to stimulate the local economy. By flooding the economy with a more money, the ECB hopes to keep up artificially low interest rates while providing consumers with extra money to spend more freely.
Reasons the ECB Uses Quantitative easing
The ECB uses quantitative easing for a variety of reasons:
1. Foster maximum employment. The ECB argues that money printed through the QE program can be used to help create jobs for citizens across the countries that share the Euro since businesses should end up with more cash on hand to finance new hiring (that’s the theory at least, critics sometimes argue that the benefits are often only temporary).
2. Encourage lending. The general premise behind this claim is that central banks can reduce long-term interest rates by buying treasuries. In providing financial institutions with more cash, these institutions should be more willing to lend out money at lower rates. Such loans then act to further stimulate the economy through higher consumer spending and business development.
3. Encourage borrowing. Low interest rates tend to encourage increased borrowing. Although this can help stimulate the economy, some argue it also has the tendency to encourage customers and businesses to take on unnecessary debt (something that the Irish Central Bank is currently trying to prevent). At the same time, some level of debt and leverage is essential to the growth of any economy, especially across many eurozone economies, including France and Italy.
4. Increase spending. The theory is that as more money enters the economy, consumers will have more to spend. This will in turn increase company profits and create more jobs. Ultimately, these factors should result in newfound consumer confidence and an economic recovery.
5. Complement low interest rates. Another tool used to stimulate the economy is the ECB refi rate. However, this tactic has already been exhausted by the ECB and has had minimal impact on economic growth in many of the major eurozone economies. This is exactly why the ECB is now about to launch the big guns of QE.
A major factor behind whether QE will actually provide long term benefits will come down to how much of the actual money that is earmarked for consumer’s pockets actually reaches its final destination. Without consumer confidence and buy-in, the prospect for a sustained recovery will remain problematic.
Risks of Quantitative Easing
Quantitative easing is not a panacea for economic recovery and has even come under fire for multiple reasons:
1. It drives inflation (much) higher. This is the biggest concern around quantitative easing which is why there has been opposition in Germany to the idea. As more money circulates through the economy, prices rise. Why? While the supply of money increases, the supply of goods remains the same. Thus, the competition for each good increases more and more leading to increased prices, which in turn leads to inflation. Excessive inflation leads to distortion of prices and incomes, and can cause an economy to operate inefficiently.
2. It creates havoc with international trade. Newly printed money can be used by the government and consumers to import new goods and services from other countries. These goods and services are more or less coming in for free. But therein lays a new problem as the value of the currency (euro) to actually purchase those goods falls, confidence in the currency falls also…it’s a bit like watered down beer, a temporary trick that will usually backfire!
3. Threat to the international perception of the Euro. Many countries get frustrated with attempts at currency manipulation like quantitative easing. In fact, in anticipation of the impact, Switzerland only just abandoned its currency peg with the euro.
4. Benefits don’t outlast QE programs. When the central bank stops printing money, the recovery often gets put on hold, or worse, begins to reverse. Although the hope is that new consumer confidence will inspire a real recovery, many feel these programs are only a short-term fix. This effect is exhibited by the fact that stock markets often fall when it is announced or speculated that the quantitative easing program will be brought to an end (as happened in the US).
5. Encourages debt. Another key worry about quantitative easing is that the increased money supply and low interest rates encourage additional borrowing by both consumers and businesses. While some debt can help stimulate an economy, excessive debt is another matter as is the case in Ireland with many businesses and consumers still struggling to exit excessive indebtedness from the pre-bust days of the Celtic Tiger.
6. More problems. While quantitative easing programs can fuel the economy, they can also dig a common currency area into a deeper hole. The key to a successful QE program is to strategically implement it just long enough to promote real and lasting improvement. Unfortunately, the ability to do so is much easier said than done.
Quantitative easing is a controversial topic for economists and politicians alike. Across the eurozone, there are many differences of opinion. Mario Draghi and his team have talked the QE game for a long time and the markets anticipate that he and his team are probably on the verge of moving ahead with QE in a massive way. This is probably why the Swiss national Bank (SNB) abandoned its currency peg. There is little doubt that the German authorities will have massive reservations about QE, after all, they are the major underwriters of the euro. For the rest of us, we’ll just have to sit tight and watch what unfolds. Will inflation return on the back of more money and if it does, what shape will the overall economy take. Will more cash mean more jobs, is this why the Irish Government moved its full employment projections forward by 2 years, who knows? Now for Mr. Draghi and his next act!