Central banks on both sides of the Atlantic took extraordinary monetary-policy measures in September: the long awaited “QE3” (the third dose of quantitative easing by the United States Federal Reserve), and the European Central Bank’s announcement that it will purchase unlimited volumes of troubled eurozone members’ government bonds. Markets responded euphorically, with stock prices in the United States, for example, reaching post-recession highs.
Others, especially on the political right, worried that the latest monetary measures would fuel future inflation and encourage unbridled government spending. In fact, both the critics’ fears and the optimists’ euphoria are unwarranted. With so much underutilized productive capacity today, and with immediate economic prospects so dismal, the risk of serious inflation is minimal.
Nonetheless, the Fed and ECB actions sent three messages that should have given the markets pause. First, they were saying that previous actions have not worked; indeed, the major central banks deserve much of the blame for the crisis. But their ability to undo their mistakes is limited.
Second, the Fed’s announcement that it will keep interest rates at extraordinarily low levels through mid-2015 implied that it does not expect recovery anytime soon. That should be a warning for Europe, whose economy is now far weaker than America’s.
Finally, the Fed and the ECB were saying that markets will not quickly restore full employment on their own. A stimulus is needed. That should serve as a rejoinder to those in Europe and America who are calling for just the opposite—further austerity.
But the stimulus that is needed—on both sides of the Atlantic—is a fiscal stimulus. Monetary policy has proven inefective, and more of it is unlikely to return the economy to sustainable growth
In traditional economic models, increased liquidity results in more lending, mostly to investors and sometimes to consumers, thereby increasing demand and employment. But consider a case like Spain, where so much money has fled the banking system—and continues to flee. Just adding liquidity, while continuing current austerity policies, will not reignite the Spanish economy.
So, too, in the United States, the smaller banks that largely finance small and medium-size enterprises have been all but neglected. The federal allocated hundreds of billions of dollars to prop up the mega-banks while allowing hundreds of these crucially important smaller lenders to fail.
But lending would be inhibited even if the banks were healthier. After all, small enterprises rely on collateral-based lending, and the value of real estate—the main form of collateral—is still down one-third from its pre-crisis level. Moreover, given the magnitude of excess capacity in real estate, lower interest rates will do little to revive real-estate prices, much less inflate another consumption bubble.
Of course, marginal effects cannot be ruled out: Small changes in long-term interest rates from QE3 may lead to a little more investment; some of the rich will take advantage of temporarily higher stock prices to consume more; and a few homeowners will be able to refinance their mortgages, with lower payments allowing them to boost consumption as well.