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As Monetary Cliff Looms, Economist Urges Fed to Increase QE

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Going very much against the zeitgeist, an influential economist is arguing that what the economic world needs now is…more quantitative easing.

Adding to all the anguished talk about tapering (i.e., easing out of quantitative easing) at the Fed, The Wall Street Journal earlier this month published “Confessions of a Quantitative Easer,” written by the former official who managed the Fed’s mortgage-backed security purchase program, and is now critical of it.

So while panning QE is in vogue, not least among economic conservatives, John Makin, a resident scholar at the free-enterprise-oriented American Enterprise Institute (AEI), has been beating the drums warning that letting up on monetary stimulus might send the global economy into a dangerous deflationary spiral.

His influential economic outlook last month warned of the extreme danger of going over the “monetary cliff,” and his warning grows more urgent in his new December outlook, updated with alarming new consumer price index (CPI) data. October U.S. CPI—which is one measure of inflation—rose at a meager 0.9% rate, down from a 2.2% pace a year ago. The disinflationary trend is even more pronounced in Europe, where the inflation rate was 3% at the end of 2011; 2% at the end of 2012; and has dropped to 0.7% in October.

“If this pace of disinflation (falling inflation) continues, Europe could be living with outright deflation by next spring,” Makin warns.

With euro area Q3 growth barely registering a pulse—at 0.1%–there is little to encourage those who might think reflation is on the way. Indeed, Makin warns that deflation has already taken root in Europe’s periphery. Bulgaria, Greece and Latvia are experiencing negative inflation; Ireland is at zero inflation; and most European countries are at or below a 1% inflation level.

The AEI scholar faults the European Central Bank’s tight monetary policy and fiscal austerity policies imposed on Southern Europe, which he says has exacerbated the area’s high unemployment (28% and 27% for Greece and Spain and 12% for the euro area as a whole).

Given the impossibility in a floating-exchange-rate world of effective currency devaluation, Makin says the only alternatives—increased QE, increased ECB security purchases, tax cuts or spending growth—are simply unlikely in the European context:

“Most of Europe is aiming at deficit reduction, spending cuts, and higher taxes, and the ECB has remained largely passive…,” he writes, adding that the ECB’s rate cut earlier this month was “largely symbolic,” given the passivity of European borrowers.

Still, a number of ECB governors opposed the rate cut, fearing—plausibly, Makin argues—the further fueling of a dangerous asset bubble.

And therein lies the central bankers’ dilemma: Push QE too far and a bubble ensues which, if allowed to burst, could “precipitate a return to recession and even a financial crisis.”

Yet given the disinflationary trends he cites, Makin warns that “a passage over the monetary cliff from disinflation to deflation threatens a self-reinforcing deflationary spiral.”

To Makin, that is the more realistic and imminent threat today. For that reason, he condemns “the Fed’s tiresome game of taper ping pong” at a time when U.S. GDP growth is heading to a rate below 1%, and argues that the ECB must recognize that price stability means not only avoiding inflation but avoiding deflation.

To that end, Makin pithily recasts 2014 plans for the Fed and ECB as follows:

“Central banks have a plan: stay easy until the economy recovers and watch out for inflation. In short, get ready to tighten. Maybe in view of an alarming global drift toward deflation (a falling price level of goods and services), tepid growth, and stubbornly high unemployment, they should think about a different plan: get ready to ease more.”