Quantitative Easing: Toward a New Liquidity Glut?

The European Central Bank’s new quantitative easing program may end up pushing liquidity into the wrong economy: the United States. This may be beneficial for the euro area in the short run as the money that flows out of Europe pushes down the value of the euro relative to the dollar and as the capital inflows into the United States fuel U.S. demand for European exports. To give you a sense of how strong this effect is likely to be, I am pasting a recent history of the euro-dollar exchange rate that dates back to the start of the Greek sovereign debt crisis in January 2010. This data is provided by the Dutch national bank.


In the long run, this movement of exchange rates and capital flows raises the prospect that European investments into the United States will lose value once the euro recovers its strength and that the liquidity pushed into the United States will wind up in assets that turn out to be far more risky than the return they offer is really worth. This formula for trouble should sound familiar. During the aftermath of the Southeast Asian financial crisis in the late 1990s, a number of countries sought solace and insurance in foreign exchange accumulation through export-led growth. Many of the assets they accumulated were denominated in dollars and he markets where they sold their exports were in the United States. This was a happy coincidence insofar as these Asian economies could effectively lend U.S. consumers the liquidity to buy Asian exports, but it created a dangerous co-dependence between American borrowing and Asian growth. If Americans should suddenly start saving – or paying down their debts, which amounts to the same thing – then Asian exporters would experience a sudden shock. That is essentially what happened in the aftermath of the subprime mortgage crisis at the start of the Great Recession from which the U.S. economy is only now just emerging.

Europe did not play much of a role in the liquidity glut that emerged as a number of Asian countries built up foreign exchange reserves in dollar denominated assets during the early 2000s. Instead, the European countries replicated a similar pattern of capital transfers within the euro area itself. This pattern was more virtuous in the sense that the countries with surplus savings were generally more developed than the countries where the savings was invested. I know a lot of North Europeans are dubious about how the money they lent to Southern Europe was put to use, but there is good evidence to suggest that much of it was spent more wisely than critics of cross-border lending might suspect.

The problem now is that the euro area is no longer in balance internally. The surpluses generated by some countries that participate in the single currency are not offset by deficits elsewhere. On the contrary, just about every country is running a surplus on its current accounts – which means that the euro area is now a net contributor to global macroeconomic imbalances. According to data released by Eurostat on 13 January, the only euro area countries that ran current account deficits in the third quarter of last year were Belgium, Latvia, Cyprus and Slovakia. The other fourteen euro area member states were in surplus and the net balance over the course of the year is estimated at over 2.5 percent of euro area GDP. This change in the pattern of European performance can be seen by looking at the current account position for the euro area as a whole (measured as a percent of GDP) plus or minus one (un-weighted) standard deviation in the current account performance across the eighteen euro area member states. Lithuania, which just joined the euro, is not present in the data published by the European Commission in its AMECO database (data line UBCA).


Many observers welcome the weakening of the euro as the surest advantage of the new quantitative easing package. As Paul De Grauwe explained on The Economist website: “Even if little else is done, QE should have a significant effect on the exchange rate of the euro. By increasing the supply of money base the ECB will contribute to a further weakening of the euro vis-à-vis other currencies such as the dollar, the pound and the yuan, thereby increasing exports and boosting inflation.” These are all good things.

But one of the lessons we learned both from the global economic and financial crisis and from the euro area crisis that followed in its wake is that big macroeconomic imbalances are to be avoided because the underlying stockpiles of cross-border investments that accumulated along the way are an implicit source of vulnerability for both sides of the transaction – the borrowers as well as the lenders. The G-20 made this point explicitly in 2008 and 2009; the European Union accepted the same logic in the negotiation of its excessive imbalances procedure. The question now is whether European politicians will take the time that the ECB has bought for them to undertake the reforms necessary to avoid repeating past mistakes.