The case for doing so is obvious. Inflation in the euro area is now just 0.4 per cent, which means that the ECB is failing in its duty to keep inflation “below, but close to, 2 per cent over the medium term.” And although the ECB expects inflation to rise in 2015 and 2016, this is by no means certain. Hence the need for measures to raise inflation.
Equally, though, there is an argument against full-blown QE. If the ECB buys the bonds of “profligate” governments, it will encourage them to borrow more. This creates a moral hazard problem which just means a bigger debt crisis in future.
From one perspective, however, this is not a bug at all, but a feature. To see why, remember the basic fiscal arithmetic about debt sustainability. This tells us that if nominal GDP growth falls further than borrowing costs - which is likely if the euro area does fall into deflation - then governments will need more fiscal austerity merely to stabilize debt-GDP ratios. However, as Marchel Alexandrovich at Jefferies points out, this could be self-defeating and governments might end up simply “chasing their own tails”: cuts in government spending would depress growth which would depress inflation and hence tax revenues even further. And if governments can’t use austerity to reduce their debt, the only option might eventually be to renege upon it. That would impose losses upon banks and create a new financial crisis.
In this sense, QE would be a form of fiscal policy. It would be an alternative to either self-defeating austerity or debt repudiation.
This raises the question: is there some way of designing QE so that it has the desirable effects of stimulating economic activity and averting horrible debt dynamics, whilst not creating a moral hazard problem?
Yes, say Luis Garicano at the LSE and Lucrezia Reichlin at the London Business School. They propose the creation of a synthetic bond, comprised of risk-free portions of governments’ debt, weighted by GDP. The ECB, it says, should conduct QE by buying this bond.
Doing this has the advantages of QE: it’ll print money to boost inflation; and it’ll help prevent the need for counter-productive austerity. They claim it will have three further advantages:
- It reduces the moral hazard problem. National governments will still be responsible for the risky portion of their debt - which will be large in southern Europe. And they will face their own interest rates on this debt, which will reflect investors’ perceptions of its quality.
- Insofar as banks will be able to hold some of this bond - not all of it will be bought by the ECB - it will mitigate the "diabolic loop" whereby falling prices of national government debt weaken the balance sheets of that country’s banks.
- The bond will be a new safe asset. It will thus help to solve the safe asset shortage which has driven down yields on safe assets.
You might think there’s a paradox here. The financial crisis of 2008 had its origins in part in the creation of synthetic assets – mortgage-backed bonds which banks thought were safe but which turned out not to be. And yet here the creation of such assets is offered as a solution.
Personally, I don’t think this is a genuine paradox. It rather highlights a flaw in our financial system, which has long been highlighted by the fact that there’s been pitifully little progress towards Robert Shiller’s proposal for macro markets to help insure us against economic fluctuations. The problem is that there has been too much bad or pointless financial innovation, and far too little useful innovation.
