Quantitative Easing: Deflation-Stopping, but Insufficient to Jumpstart Eurozone Economy says UMD Expert

Hot Topic Alert: January 15, 2015

The World Bank warns permanent stagflation faces euro-currency countries. Countering the threat, the European Central Bank (ECB) sets to unleash a round of quantitative easing (QE), which means creating money to buy financial assets, including government bonds.

Phillip Swagel, a University Maryland professor and former IMF and U.S. Treasury official, says such a move by the ECB – following the path taken by the Federal Reserve -- would avoid deflation, but economic growth in the euro area countries still looks to be slow.

Swagel, a professor in UMD’s School of Public Policy and Center for Financial Policy senior fellow at UMD’s Robert H. Smith School of Business, says:

“Quantitative easing by the ECB could help spur ailing economies in Europe by avoiding deflationary risks and by leading to a weaker Euro that improves the competitiveness of firms in countries such as Greece, Italy and Spain vis-à-vis countries outside the Eurozone.

Inflation rates in the Eurozone have been heading lower, giving rise to concerns over deflation. This worry is that deflation will lead businesses and consumers to hold off on purchases – after all, with deflation, the prices will be lower in the future. But this behavior would then mean weaker demand and even worse deflation.

QE would eventually lift inflation and avoid this outcome. Though given the weakness in the euro area economies, it could take a while for the ECB action to take hold. QE will also lead to a devaluation of the euro against the dollar.  A weaker euro will not improve the competitive situation of firms in Greece against those in Germany—after all, both countries are on the euro.  But the weaker currency will boost exports to markets outside the euro zone.”

U.S.-Based Projection

“The experience of the United States over three rounds of quantitative easing suggests that QE can support the euro area economies, but that ECB action alone is not a salve for the ailing countries. The ECB can avoid deflation and thereby head off the worst outcome of a deflationary spiral. But interest rates are already quite low in Europe, and it is hard to imagine that even a large move such as a 100 basis point decrease in real interest rates (that is, nominal interest rates adjusted for inflation), would lead to a huge increase in investment and economic growth.  This is the lesson from QE3 in the United States, that the incremental growth impact was modest. But at least the ECB can avoid deflation—and that alone is a worthwhile goal.”

Strengthening Dollar, U.S. Export Disadvantage

“For the United States, quantitative easing by the ECB would likely mean a yet-stronger dollar that further disadvantages U.S. exporting firms against their European competitors. But the bigger point is that an economically vibrant Europe is in the best interest of the United States. We want Europe to succeed – and action by the ECB looks to be an important part of that right now.”

Contact: Phillip Swagel, 301-405-1914, pswagel@umd.edu.