Since the start of this year the ECB has been applying “quantitative easing” (QE), i.e. a program injecting large amounts of money into the economy. Every month the ECB is buying 60 billion euros of government bonds and in so doing injects the same amount of money into the economy. Up to today the total amount of liquidity injection approaches 700 billion euros.
There can be little doubt that this massive injection of liquidity by the ECB has had a positive effect on exports. It led to a depreciation of the euro vis-à-vis the major currencies (dollar, pound sterling) and boosted competitiveness of Eurozone exporters compared to the rest of the world.
However, it becomes increasingly clear that QE alone is insufficient to pull the Eurozone economies out of their lethargic growth. In fact, in the second quarter of this year, growth slowed down again. There is a fear that in the next few years economic growth will remain subdued. An expanded version of QE will not solve this problem.
All this should not come as a surprise. Economists have been warning for a long time that when interest rates are close to zero, quantitative easing alone will not be able to stimulate the economy. The reason is that when the interest rates are close to zero the liquidity that the central bank is creating does not easily filter into the real economy. Most of it is hoarded because the opportunities to find attractive rates of return are limited. Many financial institutions then prefer to accumulate the extra liquidity created by the ECB without doing anything productively with it. This is the well-known liquidity trap.
Thus while QE was and is necessary, it is insufficient. It has to be seconded by fiscal policies. Here is the real problem in the Eurozone. Fiscal policies are not helpful. First, too many countries continue to be kept in the austerity straightjacket. Second, and most importantly, public investment continues to decline. But it is public investment that is key to the recovery in the Eurozone.
There are two reasons why public investment is central for promoting economic growth. First, the private sector is still very risk averse and fails to invest enough. This has to do with the lack of confidence in the future. The way to deal with this is for the public authorities to show the way and kick-start public investments. This will increase economic growth and create more confidence in the future which will stimulate private investment.
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Second, public investment is needed to achieve the long-term objectives of a green economy. The latter requires investment in alternative energy sources and in public transportation.
Unfortunately, public investment is discouraged by a stupid rule that the members of the Eurozone have imposed on themselves, i.e. that public investment cannot be financed by issuing bonds. It has to be financed by current tax revenues. This prevents public investment from taking off, from sustaining the recovery and from developing a green economy.
It is often argued that public authorities should not increase their debt; on the contrary that they should reduce it. Some countries of the Eurozone periphery undoubtedly have limited capacities to add to public debt. But other countries, like Germany, France, Belgium and the Netherlands surely can. The governments of these countries today can borrow at very long maturities almost for free. There are certainly many investment projects that have a rate of return of more than 0%.
A government that issues bonds at close to 0% and channels the money into projects that will have rates of return by far exceeding 0% promotes economic growth and makes the future repayment of the debt easier. Put differently, what matters in not gross debt, but net debt of governments. Debt issue that makes it possible to invest in assets with a much higher rate of return than the cost of borrowing (now close to 0%) will reduce net debt in the future. Unfortunately, Eurozone countries continue to be mesmerized by gross debt numbers and as a result fail to do the obvious.
It is often said that governments today should not issue more debt because this will place a burden on our grandchildren. The truth is that our grandchildren will ask us why we did not invest in alternative energy and public transportation, and thereby made their lives miserable, when we faced historically favorable financial conditions to do so.
This column was first published on Paul de Grauwe’s Blog.