It’s official: the eurozone is a step away from deflation. With a low and rapidly falling average inflation rate of 0.7% (as of January 2014) – well below the ECB’s inflation target of  ‘below, but close to, 2%’ – and most periphery and Eastern countries of the currency bloc already in outright deflation, the continent may be about to enter the most critical phase of the crisis yet. While our political leaders never tire of reminding us of the dangers of excessively high inflation, the dangers of excessively low inflation – or even worse, outright deflation (negative inflation) – are too often ignored. Deflation denotes a self-reinforcing economic vicious circle in which low demand leads to a decrease in prices, which leads to lower production, which leads to lower wages and even lower demand, which in turn leads to a further decrease in prices, which leads to growing unemployment, and so on. Moreover, by increasing the real value of the debt, low inflation also makes it increasingly difficult for countries to pay back their public debt.

Importantly, once a deflationary spiral sets in, it’s very difficult to drag one’s self out of it, and the political consequences can be devastating – as Europeans should know better than anyone else. Many historians agree that it was precisely the deflationary policies pursued by many European countries – and Germany in particular – in the 1930s that led to a deepening of the Great Depression, to the breakdown of democratic systems across the continent, and ultimately to war.

A European economy that is still too weak

The lesson here is that deflation doesn’t just ‘happen’; it’s the result of flawed, albeit interested, political decisions. And today we are repeating the same mistakes of the 1930s: as should be clear to everyone by now, by choosing the class-based and creditor-led path of demand-crushing austerity, internal devaluation and asymmetric adjustment (as deficit/debtor countries deflate but surplus/creditor countries don’t inflate), the European elites have pushed the continent into recession and entire countries into outright depression, widened the core-periphery gap, transformed an economic crisis into a full-blown social crisis, sent public debt levels through the roof. Let no one be fooled by talks of ‘recovery’; under the present macroeconomic policy settings, economic fundamentals – in particular unemployment and public debt levels – in the eurozone are bound to get worse in the coming years, with long-term stagnation the most optimistic prospect.

And, as mentioned, the situation could precipitate very rapidly if a shock of some kind were to send Europe spiralling into deflation. As even the IMF’s Christine Lagarde recently warned in Davos: ‘We need to be extremely vigilant. The deflation risk is what would occur if there was a shock to those economic now at low inflation rates, way below target. I don’t think anyone can dispute that in the eurozone, inflation is way below target.’

The real economy needs money

So, what to do? While it is clear, as the European Green Party advocates, that in the medium-long term Europe needs a ‘Green New Deal’ – a radical change of course based upon the three pillars of financial reform, sustainably industrial renaissance and social justice –, we also need to address the immediate threat of deflation and mass unemployment, by boosting demand and kick-starting the economy. To do that, we need to find ways to channel more money into the pockets of businesses and households.

Usually that job is up to banks. As we all know, though, banks are not lending; in fact, the pace of credit contraction in the eurozone is now greater than ever before. The response of the central banks of most advanced countries – most notably, the United States, the UK and Japan – has been to resort to what we shall call conventional unconventional monetary policy, or ‘quantitative easing’ (QE), by which the central bank aims to ease financial conditions by buying mortgage-backed securities and other securities, such as government bonds, from private banks in the hope of spurring bank lending. The ECB, on the other hand, has refused to engage in QE and has limited itself to what we shall call conventional conventional monetary policies: lowering its key interest rate and extending the maturity of its Long Terms Refinancing Operations (LTROs), through which banks are able to borrow unlimited funds at exceptionally low interest rates, as long as they can provide eligible collateral.

The ECB’s measures, though, have clearly failed to get banks in the currency area to start lending again – let alone revive the economy. Thus, given the relatively faster recovery of those countries that have engaged in QE, various commentators argue that is time for the ECB to follow suit. But others claim that the case for QE is much less clear-cut. They note that relative to the massive injection of ‘base money’ (central bank reserves) into the banking system in countries like the United States and the UK, the money supply that drives aggregate demand – namely, loans to businesses and households – has increased very marginally.

In short, the money has not ‘trickled down’ to those that need it the most, but instead, by inflating the prices of assets (such as government bonds), has almost exclusively benefited the wealthiest members of society who control the overwhelming majority of those assets, thus leading to even higher levels of inequality compared to the pre-crisis levels. As Krugman writes of the United States, ‘95 percent of the gains from economic recovery since 2009 have gone to the famous 1 percent.’[1] The reason is that conventional unconventional monetary policies such as QE, just like the ECB’s conventional conventional monetary policies (the cutting of the central bank’s key interest rates), are based on a fallacious view of how our monetary system works.

The monetarist or quantitative theory of money asserts that banks need excess reserves before they can loan out deposits (according to the so-called ‘money multiplier’) and thus that central banks can directly control the money supply by influencing the minimum reserve requirements of banks or by increasing reserves through QE. As post-Keynesian theory explains, though, the causality actually works in reverse: when a bank makes a new loan, it simply taps some numbers into a computer and creates brand new money ‘out of thin air’, which it then deposits into the borrower’s account. Only then, if it has insufficient reserves, does the bank turn to the central bank, which is obliged to provide reserves on demand. Pre-existing deposits aren’t even touched – or needed, for that matter. In short, the money supply is endogenously demand-driven, which is why in a deflationary-recessionary context such as the one that we find ourselves in – in which the economic and profitability prospects are so dim that banks refuse to lend, and people and businesses hold on to their cash instead of spending and investing – credit dries up, regardless of the amount of QE that a central bank engages in. This is what economists mean by a ‘liquidity trap’.

In such a context, according to post-Keynesian theory, monetary policies are not sufficient to fight recessions. They have to be combined with stimulatory fiscal policies. As we all know, though, the Maastricht framework – further tightened by the Fiscal Compact – severely limits the monetary and fiscal autonomy of member states, especially those with ‘high’ levels of public debt. At the same time, Germany has made it quite clear that it is opposed to any form of debt mutualisation in the near future. Moreover, even in the unlikely event that Germany were to agree to such a solution (or that certain countries were somehow allowed an individually-funded deficit increase), a debt-based stimulus would send the debt levels of crisis-stricken countries such as Italy and Greece through the roof, even by Keynesian standards – which in turn would put further strain on the integration process and core-periphery dynamics. So – barring an ‘exit and default scenario’ – what options does that leave us within the context of the EMU?

Time for a new solution

As it turns out, not all hope is lost. There is in fact a radical solution that is gaining increased support even in mainstream circles: ‘overt money financing’, or what renowned journalist and financial economist Anatole Kaletsky calls ‘quantitative easing for the people’ (QEP). We shall call this unconventional unconventional monetary policy. It basically consists in handing out newly created money, debt-free, directly to governments instead of banks. In short, if QE consists of injecting liquidity into the banks in the hope that this will percolate into the wider economy, QEP consists of bypassing banks altogether and injecting this money into the non-financial economy of consumption, investment and jobs, through direct cash hand-outs to citizens (in the form of an unconditional basic income, for example) and tax cuts, or even better, by financing public works. The central bank would in effect be financing the government’s expenditures by ‘printing’ money.

As economists Biagio Bossone and Richard Wood write, recent analyses of alternative policy options demonstrate that QEP ‘offers to deliver the most powerful stimulus possible without increasing interest rates or public debt’, and could even be implemented without violating Article 123 of the Lisbon Treaty[2]. Moreover, it doesn’t raise any issues of mutualisation, since present and future taxpayers, including those in core countries, wouldn’t run any risk of having to bail insolvent states or incur higher debt-servicing costs in the future. Similarly, there would be little risk of inflation, since excess liquidity could always be sterilised in the future. While most people would balk at the idea, it should be noted that QEP has been defended in the past by such eminent and diverse economists as Henry Simon, Irving Fisher, John Maynard Keynes, Abba Lerner, Milton Friedman and Ben Bernanke, and has been recently revived by a number of well-known scholars and policy-makers, including Adair Turner, member of the UK Financial Policy Committee and former chair of the Financial Services Authority.

The ideas was recently championed even by the Committee on Economic and Monetary Affairs in a 2013 draft report on the activities of the ECB which recommended that the central bank ‘undertake an “overt money financing” of government debt in order to finance tax cuts targeted on low-income households and/or new spending programmes focused on the Europe 2020 objectives’. The proposal was ultimately struck down, but the simple fact that it was debated offers a glimmer of hope for the future. It is only by challenging the dominant and tragically flawed economic and monetary orthodoxy that we have any hope of escaping the crisis, and of rebuilding Europe on the basis of a socially and environmentally sustainable economy.



[1] Paul Krugman, ‘Rich Man’s Recovery’, New York Times, 12 September 2013.
[2] Biagio Bosson and Richard Wood, ‘Overt Money Financing of Fiscal Deficits: Navigating Article 123 of the Lisbon Treaty’, EconoMonitor, 22 July 2013.

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