Doubts about European quantitative easing persist despite its early successes in the markets, particularly in devaluing the euro in foreign exchanges. Skepticism centers on the so-called free-rider problem—that the more heavy lifting European Central Bank President Mario Draghi does, the less European politicians will do to promote essential structural reforms. Even Mr. Draghi agrees that monetary policy by itself cannot produce sustainable growth.
But if the free-rider argument were correct, you would expect the severe economic pressure of the past several years on the eurozone periphery countries—Portugal, Italy, Greece and Spain—from deflation and stagnation to have generated structural reforms. That has not happened. The pressure has been there but the reforms haven’t. Why should taking the pressure off stymie reforms when putting the pressure on hasn’t encouraged them?
Pressure is only part of the story. Structural reform is costly in the short run. Countries under severe economic pressure may be unable to afford structural reforms even if they understand their longer-term benefits.
It’s like people who believe they can’t afford to go to college. They know that they will likely suffer in the long run because of a lack of a college education, but they don’t have the money.
Now, however, by fighting deflation and anemic growth, the ECB’s quantitative easing makes reform more affordable. This happens in two major ways. The first is by devaluing the euro. Before a single bond was bought by the ECB, the dollar value of the euro dropped to $1.08 from $1.40. That’s a big move—and it came in anticipation of the program and not because Mr. Draghi is a good salesman, which he is.
The second way is that QE should lower interest rates on periphery debt, reducing the interest rate costs of financing the peripheries’ budget deficits. The most direct way this happens is by ECB purchases of periphery bonds. But there are other indirect channels by which QE can affect periphery interest rates.
By signaling investors that the ECB is serious about fighting deflation and stagnation, QE should reverse the “safe haven” flow of funds into Germany. This should raise interest rates in Germany and reduce them in the peripheries. Interest rates in the periphery also could benefit from German banks trying to escape negative interest rates and possible insolvency in a conventional scramble for higher yield.
Affordability by itself may still not be enough to spur structural reform. Periphery politicians must have powerful incentives to overwhelm the conventional free-rider disincentives. The basket case that is Greece, the ultimate reform laggard, should be incentive enough.
No country wants to be in Greece’s shoes. Its unemployment tops the eurozone at 25% and the Greek economy is falling apart as it bargains for a better deal from creditors. If the Greeks leave the eurozone, they will go through hell. If they stay, they also will go through hell. What other periphery country would want that?