When QE is not enough
CAMBRIDGE, Massachusetts - Although the European Central Bank has launched a larger-than-expected program of quantitative easing (QE), even its advocates fear that it may not be enough to boost real incomes, reduce unemployment and lower governments’ debt-to-GDP ratios. They are right to be afraid.
But first the good news: anticipation of QE has already accelerated the decline of the euro’s international value. The weaker euro will stimulate eurozone countries’ exports - roughly half of which go to external markets - and thus will raise eurozone GDP. The euro’s depreciation will also raise import prices and therefore the overall rate of inflation, moving the eurozone further away from deflation.
Unfortunately, that may not be enough. The success of QE in the United States reflected initial conditions that were very different from what we now see in Europe. Indeed, eurozone countries should not relax their reform efforts on the assumption that ECB bond purchases will solve their problems. But even if these countries cannot overcome the political barriers to implementing structural changes to labor and product markets that could improve productivity and competitiveness, they can enact policies that can increase aggregate demand.
To be sure, the major eurozone countries’ large national debts preclude using traditional Keynesian policies - increased spending or reduced taxes - to raise demand through increased budget deficits. But eurozone governments can change the structure of taxes in ways that stimulate private spending without reducing net revenue or increasing fiscal deficits.
First, though, consider why QE’s ability to stimulate growth and employment in the United States does not imply that it will succeed in the eurozone. QE’s effect on demand in the United States reflected the financial-market conditions that prevailed when the Federal Reserve began its large-scale asset purchases in 2008. At that time, the interest rate on ten-year Treasury bonds was close to 4 percent. The Fed’s aggressive program of bond-buying and its commitment to keep short-term interest rates low for a prolonged period drove the long-term rate down to about 1.5 percent.
The sharp fall in long-term rates induced investors to buy equities, driving up share prices. Low mortgage interest rates also spurred a recovery in house prices. In 2013, the broad Standard and Poor’s index of equity prices rose by 30 percent. The combination of higher equity and house prices raised households’ net worth in 2013 by $10 trillion, equivalent to about 60 percent of that year’s GDP.
That, in turn, led to a rise in consumer spending, prompting businesses to increase production and hiring, which meant more incomes and therefore even more consumer spending. As a result, real (inflation-adjusted) GDP growth accelerated to 4 percent in the second half of 2013. After a weather-related pause in the first quarter of 2014, GDP continued to grow at an annual rate of more than 4 percent.
Thus, QE’s success in the United States reflected the Fed’s ability to drive down long-term interest rates. In contrast, long-term interest rates in the eurozone are already extremely low, with 10-year bond rates at about 50 basis points in Germany and France and only 150 basis points in Italy and Spain.
So the key mechanism that worked in the United States will not work in the eurozone. Driving down the euro’s dollar exchange rate from its $1.15 level (where it was before the adoption of QE) to parity or even lower will help, but it probably will not be enough.
But, fortunately, QE is not the only tool at policymakers’ disposal. Any eurozone country can modify its tax rules to stimulate business investment, home building and consumer spending without increasing its fiscal deficit, and without requiring permission from the European Commission.
Consider the goal of stimulating business investment. Tax credits or accelerated depreciation lower firms’ cost of investing and therefore raise the after-tax return on investment. The resulting revenue loss could be offset by raising the corporate tax rate.
Similarly, demand for new homes could be increased by allowing homeowners to deduct mortgage interest payments (as they do in the United States), or by giving a tax credit for mortgage interest payments. A temporary tax credit for home purchases would accelerate home building, encouraging more in the near term and less in the future. Here, the revenue loss could be offset by an increase in the personal tax rate.
A commitment to raise the rate of value-added tax by 2 percentage points annually for the next five years would encourage earlier buying to get ahead of future price increases. The reduction in real incomes caused by the VAT increase could be offset by a combination of reduced personal income taxes, reduced payroll taxes and increased transfers.
Though eurozone members cannot adjust their interest rates or their exchange rates, they can alter their tax rules to stimulate spending and demand, with the appropriate policy possibly differing from country to country. It is now up to national political leaders to recognize that QE is not enough - and to start thinking about what else should be done to stimulate spending and demand.
Copyright: Project Syndicate, 2015.
*The author, a professor of economics at Harvard University and president emeritus of the National Bureau of Economic Research, chaired President Ronald Reagan’s Council of Economic Advisers from 1982 to 1984.
by Martin Feldstein