What happens if, as people have been demanding, the European Central Bank starts to buy euro-zone debt?
Let’s assume the ECB is allowed to put aside its scruples about monetizing the debt of euro-zone countries shut out of the markets and decides to force yields down to where spreads are no more than a hundred or so basis points above German paper.
If announced forcefully enough, the ECB’s monetary howitzer would almost certainly drive down yields even in Greece. In effect, the ECB would guarantee a ceiling on yields, making sovereign debt across the whole of the continent a screaming buy in euro terms.
But because Europe’s periphery is facing a crisis of solvency rather than just liquidity, the ECB would be left carrying the losses.
It would need to be recapitalized either by stronger core governments or through the printing presses.
And that’s what most of those calling for an ECB bond-buying program are saying: recapitalize Europe’s periphery through the printing presses; make Europe’s savers pay by inflating away the value of their currency. Because that’s what would happen. An ECB printing program would cause the euro to fall in value on the currency markets and push up inflation.
This devaluation and inflation would provide a boost to European manufacturers and, therefore, to the euro-zone economy.
But the question then would be: how would other countries respond?
Probably not happily.
That’s because while expanded global trade is generally a net benefit, at times when all countries are struggling to maintain domestic demand trade becomes more of a zero-sum game.
Were a euro devaluation to boost trade, that growth would come more from sales to the U.S. and the U.K. and other European non-euro countries rather than to robustly growing emerging markets like Brazil and China, which could well be able to absorb the imports.
This would mean slower growth in the U.S. and U.K. and non-euro Europe and a likely consequent response of further monetary stimulus from these countries as they try to devalue their way to competitiveness as well.
Another, more pernicious, possibility is that countries would start to use trade barriers to stave off competition. That’s because, at some point, central banks will come to be worried that their grossly over-expanded balance sheets could trigger a sudden surge of inflation.
In the near term, even without triggering out-of-control inflation, monetary stimulus would mean rising prices of raw goods as we go through the same cycle we’ve gone through over the past four years: monetary easing, commodity-price surge, constraint on real consumption and finally economic slowdown.
This would benefit emerging markets and commodity producers. It would tend to force their currencies higher or push up domestic inflation.
Ultimately, these cycles of competitive devaluation would engineer the required transfers from creditor to debtor countries. But the road would be a rough one and trade wars would almost certainly be ignited along the way.