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Economists' roundtable on the euro zone - QE is no silver bullet

2014-11-06 13:12:27

Nov 6th 2014, 9:28 by Demosthenes Tambakis | University of Cambridge

Continuing our discussion of QE and the euro zone is Demosthenes Tambakis of

the University of Cambridge. The other contributions to the roundtable are

here, here and here.

One could list several reasons why full-blown quantitative easing (QE) cannot

save the euro.

Below I outline three, each working at different timeframes.

First, in the short term falling oil prices are likely to cause a further round

of deflationary pressure. That is because favourable supply shocks tend to be

recessionary when constrained by the zero lower bound of nominal interest

rates, just as adverse ones are likely to be expansionary. Falling input prices

results in lower expected inflation, driving up short-term real interest rates

as the policy rate cannot adjust. Hence, the ECB s timing occurs at the wrong

point in the global oil and commodity cycle: adopting full-blown QE now may

amplify deflationary tendencies.

Second, in the medium term the euro-zone banking system remains very fragile

compared to America s, and no amount of QE can fix that. If a contagious

banking crisis is to be avoided, the 5% leverage ratio being implemented in

America will soon have to be adopted by systemically important European banks

whose ratios stand closer to 3%. In that respect, the recent bank stress tests

amount to mere window-dressing because, unlike the Fed/FDIC regulatory

framework, the ECB is only empowered to supervise financial institutions, not

to resolve failed banks. Markets understand this to mean that the clean-up

costs of a banking crisis will inevitably land on euro-zone taxpayers. In turn,

this amplifies deflation/recession dynamics.

Third, in the long term a fiscal transfer union is a necessary condition for

the euro zone to survive as argued by countless analysts since before the

single currency s launch, monetary and currency union alone are insufficient.

Moreover, there is currently even less appetite for a fiscal union as the core

member states (Germany and France) cope with their own slowdowns. There may

also be a vicious circle at work, whereby the alarming increase in votes for

far-right parties deeply anti-Europe and anti-immigration coupled with

entrenched high unemployment fuel anti-euro resentment.

Against a lacklustre GDP growth record since 2002 and a dismal one since 2008,

I thus consider it highly improbable that QE can turn the tide. Even faced with

a counterfactual such as euro-zone austerity is expansionary (on which there

is scant empirical or theoretical support, particularly at the zero bound), it

is hard to see how the euro will not weaken dramatically at some point before

unravelling or shrinking to a core euro zone of 5-6 countries.

Worse, removing that day of reckoning now requires addressing dangerous

centrifugal politics as well as procrastinating economics. No wonder that

investor confidence in the euro is so fickle.