No Free Lunch for the ECB

By Desmond Lachman

The IMF is urging the ECB to implement massive quantitative easing, but such a course of action is unlikely to promote short-term economic growth and would risk creating bigger bubbles in many asset markets.

Milton Friedman was fond of saying of economic policy choices that there was no such thing as a free lunch, meaning that an economic policy option that appears to offer an attractive choice in the short run usually has negative longer-run consequences that outweigh any advantages.
Friedman’s observation certainly applies to the unprecedented expansion in the Federal Reserve and the Bank of Japan’s balance sheets over the past few years. While those expansions might have provided much-needed short-term support to the U.S. and Japanese economies, they have done so at the cost of creating bubble-like conditions in many different global asset markets. If our long past history with bubbles is any guide, this would suggest that the long-run costs of those central banks’ largesse is yet to be felt.



A striking consequence of the recent massive money printing by the Federal Reserve and the Bank of Japan is that it has caused not only domestic but also global financial markets to become largely disconnected from underlying economic and political fundamentals. In particular, as the Bank for International Settlements recently observed, despite very lackluster global economic conditions and heightened geopolitical risks in the Middle East and Ukraine, global equity markets remain undaunted and move from one record high to the next. Meanwhile, high-yield corporate bond markets and the markets for European sovereign debt grossly misprice risk, while financial market volatility sinks to record lows.

Global financial markets have become largely disconnected from underlying economic and political fundamentals.

The driving force underlying the financial markets’ present buoyancy has been investors’ search for yield in an unprecedented period of extraordinarily low interest rates afforded by the central banks’ money-printing activities. In their desperate search for yield, investors have become impervious to the dangers that might lurk ahead. In the process, capital has been poorly allocated as companies and sovereigns with poor economic fundamentals have been able to readily tap the capital market.
Surprisingly, at a time when even Federal Reserve Chair Janet Yellen recognizes that there are pockets of excess in global financial markets and when the Fed is exiting its quantitative easing program, the International Monetary Fund is urging the European Central Bank to emulate the massive quantitative easing programs of the Fed and the Bank of Japan. The IMF believes this would help prevent Europe from slipping into a period of Japanese-style deflation. However, such a course of action is unlikely to be effective in promoting short-term economic growth in Europe’s already low-interest-rate environment.
Before rushing to embrace the IMF’s monetary policy advice, the ECB should consider that any large-scale quantitative easing at this stage would run the risk of further inflating both European and global asset bubbles, much as the Fed and the Bank of Japan’s rounds of quantitative easing have done. That would risk a hard economic landing once global interest rates start to be normalized. Any benefit to short-run economic growth might be more than offset by the impact of an asset price bust further down the road.

European policymakers should weigh alternative policy options. 

The ECB should also question how effective quantitative easing is likely to be in lifting European economic growth. With long-term European interest rates already at very low levels, there is relatively little mileage to be obtained from a further reduction in interest rates. There’s room for a substantial cheapening in the value of the euro, but such a course of action would run the risk of reigniting charges of a global currency war, especially considering Europe’s lack of any balance of payments needed for a cheaper currency.
Before opting for a policy of quantitative easing, European policymakers should weigh alternative policy options. They might consider supporting the ECB’s present monetary policy with more expansionary fiscal policies for suitable countries, such as Germany. They might also consider policies aimed at increasing the flow of credit and at reducing borrowing costs for small and medium-sized firms in the European periphery, which is in need of a boost to its short-term economic growth prospects.