Faced with very low or even negative inflation rates, and with its own more traditional short-term policy interest rates locked up against their zero lower bound, the European Central Bank (ECB) introduced a set of nonstandard expansionary policy measures in the second half of 2014. These included a negative interest rate on banks’ deposits held at the ECB, long-term loans to financial institutions, and the purchase of asset-backed securities and private bonds covered by collateral. Finally, in January 2015, the ECB announced that it would start purchasing government bonds, thus completing its own program of quantitative easing (QE). Implementation of QE began in March, at the pace of about 60 billion Euro per month.
These new policies aim to stimulate domestic demand, so as to increase economic growth, reduce unemployment, and, above all, counteract the trend towards deflation. Importantly, in announcing them, the ECB reaffirmed its commitment to bring inflation back to its target of “below, but close to, two percent over the medium term.”
In principle, the ECB’s initiatives appear quite sound. The quantity theory of money, on which the ECB’s famous “two-pillar” policymaking strategy rests, describes how additional bank reserves, created through central bank lending and asset-purchase programs, generate growth in broader measures of the money supply that may increase output and employment in the short run and certainly raise inflation over intermediate horizons. Descriptions of these effects of money growth can be found in writing that extends back to David Hume’s 1752 essay, “Of Money.”
But will the European version of QE work in practice? Many analysts remain skeptical. However, the Eurozone’s own previous experience suggests strongly that policies directed at increasing the rate of money growth have had exactly those effects predicted by theory. The figure below shows this, by comparing year-over-year growth rates of the M1 monetary aggregate and real domestic demand, measuring inflation-adjusted spending by all European consumers, businesses, and governments. In order to account for the delay with which monetary policy actions affect the economy, the graph lags the rate of money growth by one year, reflecting, more specifically, the assumption that the rate of money growth during any given year will have its strongest effects on the economy three to four quarters later.
The graph confirms that movements in money growth have consistently presaged movements in aggregate spending. During the earliest stages of the financial and economic crisis of 2008, the ECB introduced a set of expansionary policy measures, generating faster money growth to help pull the Eurozone out of the “Great Recession.” Conversely, and tragically, a premature tightening of monetary policy during 2011 appears to have reinforced the contractionary effects of the Eurozone sovereign debt crisis, sending demand growth back into negative territory. However, renewed monetary expansion undertaken in 2012 and 2013 under Mario Draghi’s new leadership appear to have rekindled growth in demand.
Especially given the aforementioned lags in the effects of monetary policy, it would be a mistake to attribute the modest uptick in Eurozone growth during the first quarter of 2015 to the effects of QE on the money supply. Other factors, including the sharp fall in world oil prices, have surely played a more important role. Nevertheless, money growth has accelerated noticeably in recent months. Historical patterns therefore suggest that the most beneficial effects of QE will reveal themselves next year, with even stronger growth in spending due at the start of 2016.
Europe, perhaps even more than the United States, faces difficult economic and political challenges in the years ahead. Slowing population growth will continue to place severe pressure on public retirement and health care programs, and persistent fiscal deficits will require painful adjustments to tax and spending plans. Large-scale disruptions that might follow from a default on its debt by Greece or another sovereign cannot be ruled out. These are all nonmonetary problems, which central bankers cannot, and should not even try to, solve by themselves.
The European example shows, however, that monetary policy can still play a key role. By keeping the money supply on a steady path, central bankers can generate more stable growth in spending and employment and avoid the unnecessary costs imposed by excessive inflation on the one hand and unexpected deflation on the other. The backdrop of monetary stability they create will give democratic political systems their best chance to work as well, to find acceptable solutions to tougher, more longstanding, structural problems.
Peter Ireland is a Professor of Economics at Boston College and a member of the Shadow Open Market Committee. You can follow him on Twitter here. Darko Oračić is an economic analyst at the Croatian Employment Service; his views expressed herein do not necessarily reflect the views of that institution.
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