To see why, remember the simple maths of debt sustainability. This tells us that if the government wants to stabilize its ratio of debt to GDP it must run a primary budget balance (that is, the balance excluding debt interest payments) equal to:
D* [(r-g)/1+g]
Where D is the current debt-GDP ratio, r the nominal bond yield and g the nominal growth rate.
Let’s fill in the numbers for Italy. D is 1.47 and r is 3.6 per cent or 0.036. We don’t know what future real growth will be, but let’s call it the same as it has been for the last 20 years, which has been 0.7 per cent per year. And let’s assume zero inflation, so nominal growth equals real growth. It then follows that Italy needs a primary budget surplus of 4.2 per cent of GDP per year to stabilize D. This means there can be no significant easing of its current fiscal stance; the OECD expects the cyclically-adjusted surplus this year will be 4.5 per cent of GDP.
This is bad enough. But if prices fall by one per cent a year, things get really nasty. If bond yields and real growth don’t change, the country would then need a surplus of 5.8 per cent of GDP per year to stabilize debt. That means more austerity.
Deflation thus makes the problem of high debt even worse.
You might object that deflation would reduce bond yields, making the maths less nasty. Not necessarily. Deflation is great for bonds only if their repayment is guaranteed. Such a guarantee is greater in Germany than in southern Europe, so deflation could see bond investors flock out of the south into Germany which might actually raise yields in the south.
What’s more, I’ve assumed that deflation doesn’t affect real growth. But it might. If people postpone buying goods in anticipation of falling prices, real growth will falter. That will make the maths even worse.
Worse still, as Princeton University’s Christopher Sims argued at the recent Lindau meeting of Nobel laureates, expectations of fiscal austerity can themselves be deflationary, because people will save more today in anticipation of future tax rises or benefit cuts. This raises the danger of a vicious circle in which government attempts to reduce debt merely increase the deflation which renders that debt unsustainable.
Herein lies one case for quantitative easing. It helps improve two of the variables in our equation. Insofar as the ECB would buy bonds with the money it prints, it helps reduce bond yields. And as printing money would help defeat deflation, it would also improve nominal growth. It might also raise real growth, not least by reducing the danger of that vicious circle of deflation and weak economic activity, which would help improve business and consumer confidence.
This isn’t to say that QE is a magic bullet. As the UK discovered in 2010-12, it isn’t sufficient to generate strong growth if economies face other problems such as fiscal austerity and a lack of bank lending. But it might be enough to stave off a horrible disaster. Which might be the best we can hope for.
