THE CONTRAST between the monetary policies pursued in America and the euro zone since 2012 could not be greater. Since 2012 the Fed has continued to expand its balance sheet dramatically. From 2012 to 2014 the Fed added $1 trillion to its balance sheet. In doing so, it increased the American money base (liquidity) by approximately the same amount.
Exactly the opposite occurred in the euro zone. After having expanded its balance sheet during the period 2008-11, pretty much as the Fed had done, the ECB started a period of dramatic contraction in its balance sheet (and thus in the euro money base) from 2012 onwards. As a result, in 2014 the ECB had reduced the money base by €1 trillion. This was the period during which the Fed added $1 trillion to the money base, an increase of 25%.
There can be little doubt that the decision of the ECB to reduce the money base by 30% at a time when the euro zone had not recovered from the sovereign-debt crisis contributed to pushing the euro zone into a deflationary dynamic, out of which it still tries to extricate itself.
Why is it that monetary policies in America and the euro zone diverged so strongly? My answer is that it had much to do with a different diagnosis of the nature of the economic and financial crisis that hit the industrial world and the role of the central bank in dealing with such a crisis.
The American monetary authorities, correctly, understood that the crisis had led to a balance-sheet recession, i.e. an attempt by private agents to deleverage. Private agents did this by reducing spending. It was the view of the American monetary authorities that this reduction in aggregate demand had to be countered by monetary expansion.
The ECB, on the other hand, was caught in a narrative that the problem came from the supply side. There were too many rigidities on the supply side. If these were fixed by structural reforms output would increase by itself. Demand would adjust automatically to the supply.
For too long the ECB believed in this narrative, lecturing governments to do their part by introducing structural reforms. In this view, monetary policies were powerless to move the economy.
Only by the beginning of 2014, the ECB started to recognise that this narrative did not fit the facts. Deflationary dynamics were not stopped despite the fact that quite a number of euro-zone governments introduced structural reforms. As a result the ECB announced its desire to do some quantitative easing, i.e. to stop reducing its balance sheet.
However, in the face of the fierce opposition of German economists and media the ECB was caught in a double bind. German opposition made it impossible for the ECB to use the technically easiest way to increase the money base, i.e. buying government bonds. Government-bond purchases, which in nations like America, Britain and Sweden are considered to be technical operations, are resisted with religious zeal in Germany and paralyse the ECB. As a result, the ECB was forced to resort to schemes that are technically difficult to implement because of a lack of liquid markets for those assets, e.g. buying repackaged loans of small- and medium-sized companies.
Thus, the ECB announced QE but found itself in a quandary: the easy instruments were forbidden for quasi-religious reasons. The instruments that the ECB was allowed to use are technically demanding and will not make possible a big increase in the money base.
The question that arises now is what the ECB should do.
At a minimum it should take its responsibility of keeping inflation close to 2% seriously. For two years it has failed to reach this objective. The only way to reach it is to increase the money base and the only practical instrument that can be used to achieve this goal is a purchase of government bonds. This is standard economics. The ECB should recognise this and should not be distracted by non-scientific objections to the use of that instrument.
Some fear that an increase of central-bank liquidity will only lead to asset inflation. This fear is unfounded. Asset inflation is the mechanism that can pull the euro zone out of its deflationary dynamics. It should be tried.
Failure to do so will keep the euro zone at a low-growth and high-unemployment “equilibrium”, which risks turning away millions of people from a union that instead of bringing them economic welfare leads them into economic misery. By not acting forcefully today the ECB risks unleashing the rejection of the monetary union. This is a much higher risk than the risk of German ire against the use of an instrument, the purchase of government bonds that in the rest of the world is considered to be standard practice.