Europe’s Monetary Experiment Not Working!

How can we get a little inflation around here?!
Photo Credit: Canstockphoto.com/Bialasiewicz

Do you remember how the European Central Bank (ECB) decided to try to add more zing to the Eurozone’s economy by adding quantitative easing (QE) to negative interest rates? (if not, please read The Insanity of Negative Interest Rates and The Bad Examples of the ECB and BOJ.) Well it seems not to be working very well, as the Eurozone slid back into deflation in February!     

A post on the Wall Street Journal’s website, Eurozone Slides Back Into Deflation, attributes this deflation to very cheap oil and sluggish European economic growth. While these factors are certainly part (maybe even the largest part!) of the explanation, we also have some historical evidence that QE itself is intrinsically deflationary. By reducing real long-term interest rates effectively to zero, QE destroys income for those, such as the retired, who depend on long-term bonds for their living. As a result older, retired individuals are much more careful about expenditures, causing money velocity, and therefore inflation, to decline. If inflation is already effectively zero, a serious decline in money velocity could easily push inflation into negative territory to become deflation. And as I discussed in Should We Expect Inflation or Deflation? and in What Does Falling Money Velocity Tell Us?, falling money velocity is definitely a major reason for the absence of inflation in the U.S. (The other major reason for the lack of U.S. inflation is the recapture of approximately 81% of new QE money back into excess reserves in the Federal Reserve.) In the last two posts cited, I displayed the following plot of M2 money velocity using data from the Federal Reserve Data.

The blue curve is the actual money velocity, while the red curve is its percent change from a year ago. As you can see, the money velocity has been falling fairly steadily since the start of the recovery from the Great Recession.

In fact money velocity has been consistently falling for Europe, Japan, and the U.S. since around the turn of the century as seen in the plot below taken from the Business Insider post QE doesn’t cause inflation, it causes deflation.

[Note: the U.S. curve looks somewhat different from the previous plot because of the start of the x-axis at the year 1998 rather than 1959 and a stretching of the curve on the x-axis.] Therefore, there is something more going on than just QE, because QE did not start in the U.S. until November 2008. However, there was a big drop in money velocity corresponding to the beginning of QE in the United States. The universal drops in velocity prior to that date might be due to cumulative effects of government policies inhibiting business activity.

Next week on March 9 and 10, the ECB’s governing council will meet to decide just what they can possibly do about all this. For some reason (just like the Federal Reserve), they think an inflation rate just below 2% will be good for economic growth. It seems the Phillips curve lives on in the imagination of European Keynesians no less than with American Keynesians. Mario Draghi, the ECB President, has reportedly declared the ECB will not hesitate to act if it believes they can not reach this inflation goal. Since the ECB has already embraced a Negative Interest Rate Policy (NIRP), they could either make interest on excess reserves more negative, or they could make even more QE purchases. Given past history, more QE would appear to be counterproductive. Therefore, I would expect they would make NIRP even more negative to scare banks into pulling their excess reserves to inject into business loans.

It will be fascinating to see not only what the ECB plans to do, but also what results later. Could it be governments have so discouraged economic growth that falling money velocity would merely fall even more to cancel out the effects of NIRP?

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