The ECB’s New Macroeconomic Realism

NEW YORK – The European Central Bank has finally launched a policy of quantitative easing (QE). The key question at this stage is whether Germany will give the ECB the freedom of maneuver needed to carry out this monetary expansion with sufficient boldness.

Though QE cannot produce long-term growth, it can do much to end the ongoing recession that has gripped the eurozone since 2008. The record-high stock-market levels in Europe this week, in anticipation of QE, not only indicate growing confidence, but are also a direct channel by which monetary easing can boost both investment and consumption.

But some observers, such as Nobel Laureate Paul Krugman and former US Treasury Secretary Larry Summers, continue to doubt whether QE can really be effective. As Krugman recently put it, a “deflationary vortex” is dragging down much of the world economy, with falling prices causing an inescapable downward spiral in demand. The World Bank and International Monetary Fund seem to agree, as both recently lowered their growth forecasts a few notches.

Pessimists argue that the world economy suffers from an insurmountable shortage of aggregate demand, leading to a new “secular stagnation.” Monetary policy is seen to be relatively ineffective, owing to the notorious zero lower bound (ZLB) on nominal interest rates. With policy interest rates near zero, the argument goes, central banks are more or less helpless to escape the deflationary vortex, and economies become stuck in the infamous liquidity trap. In this scenario, the demand insufficiency feeds on itself, pushing down prices, raising real (inflation-adjusted) interest rates, and lowering demand further.