The Eu­ro­zone needs more than QE

Financial Mirror (Cyprus) - - FRONT PAGE -

Although the Euro­pean Cen­tral Bank has launched a larg­erthan-ex­pected pro­gramme 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 US does not im­ply that it will suc­ceed in the eu­ro­zone. QE’s ef­fect on de­mand in the US 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%. The Fed’s ag­gres­sive pro­gramme 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%.

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%. The com­bi­na­tion of higher eq­uity and house prices raised house­holds’ net worth in 2013 by $10 tril­lion, equiv­a­lent to about 60% 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% 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%.

Thus, QE’s suc­cess in the US 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 ten-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 US 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 US), 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 two 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 recog­nise that QE is not enough – and to start think­ing about what else should be done to stim­u­late spend­ing and de­mand.

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