Will ECB Break Its Bond-Buying Taboo?

WSJ: For five years, the European Central Bank has resisted calls for it to engage in quantitative easing. Is it time to break this final taboo? Last week's euro-zone third-quarter gross-domestic-product data offered something for both sides of this increasingly polarized debate.

For the ECB's critics, the data merely underlined the feebleness of the recovery: GDP grew by just 0.1% in the quarter, down from 0.3% in the second quarter and well below levels in the U.S., Japan and U.K. Particularly worrying was a surprise 0.1% slide in French GDP. At the same time, the European Commission warned that Italy and Spain were unlikely to meet their budget deficit targets in 2014.

For many, this is proof that the euro zone's crisis response, centered on fiscal austerity and structural reform, has failed. They insist that the core problem is a lack of demand that policy makers have a responsibility to address either by borrowing and spending themselves, or by printing money to drive down borrowing costs to encourage the private sector to borrow and spend instead. They argue that growth will beget growth as confidence spreads and underutilized resources are brought back into productive use. They offer the recoveries in the U.S. and Japan, which grew at annualized rates of 2.8% and 1.9% in the third quarter, as proof that aggressive stimulus works.

The alternative view is that it is simply too soon to tell whether all this stimulus will bring long-term benefit. What is not in doubt is that prolonged money-printing is having profound distributional consequences: A study by the McKinsey Global Institute found that the biggest beneficiaries are governments, which have seen their borrowing costs driven down, and the wealthy, who have seen the value of their assets driven up, fueling inequality; the losers have been savers and pensioners, who have seen their incomes hit, and ordinary workers, who have seen prices increase without any corresponding rise in wages.

As Federal Reserve chairwoman-designateJanet Yellen acknowledged in her Senate confirmation hearings last week, quantitative easing is an unprecedented experiment whose success can't be judged for certain until it has been unwound.

Besides, many European policy makers believe that critics are overlooking evidence that the euro zone is stabilizing. Portugal reported a second quarter of positive growth; Spain confirmed its first quarter of growth in over two years, albeit a modest 0.1% rise; the annualized pace of decline in Greece slowed to 3%, boosting hopes of a return to growth next year; and Ireland demonstrated confidence in its prospects by announcing it would exit its bailout program with no emergency backstop. Equally encouragingly, German domestic demand unexpectedly rose and exports fell, confounding recent critics of its economic model and offering further evidence that confidence is returning.

What's more, some argue that focusing on demand-side weakness misdiagnoses the nature of the euro crisis. According to this analysis, the depth of the recessions in Southern Europe reflect serious policy failures before the crisis rather than mistakes now. Italy and Portugal failed to grow for a decade before the crisis, while growth in Ireland, Spain and Greece was fueled by unsustainable explosions in public- and private-sector debt.

Indeed, the politically charged debate around austerity obscures the fact that those countries that have experienced the deepest recessions have tended to be those that experienced the greatest loss of competitiveness, scored badly on ease of doing business surveys, or showed up worst in surveys of educational achievement or measures of technological sophistication such as Internet usage, notes Lorenzo Bini Smaghi, a former ECB executive director.

On this analysis, the euro zone's core problems lie not on the demand side but the supply side. Growth has been hampered by structural rigidities that have prevented resources being reallocated to where they can earn an economic return. These rigidities include restrictive labor rules, overgenerous welfare provisions, broken banking systems, inefficient bureaucracies, failing education systems, unbalanced tax systems or flawed justice systems that can't guarantee the timely and transparent exercise of contractual rights.

Unless these rigidities are addressed, a fresh borrowing binge risks fueling a further misallocation of resources and may make debt problems worse. The only long-term solution is radical reform of the sort that much of Southern Europe ducked for decades.

The good news is that the strong export performance in Ireland, Spain and Portugal suggests the payback from structural reforms may be even quicker than many expected, says Huw Pill, chief European economist at Goldman Sachs.

At the same time, the rapid reversal of current account deficits, recent reductions in levels of unemployment, marked easing in financial conditions and less aggressive budget cuts anticipated next year should underpin the recovery: Indeed, after five years of deeply depressed corporate investment, medium-term growth rates in Southern Europe could be "surprisingly strong," says Credit Suisse.

But even if the ECB has good reasons to resist pressure to launch a bond-buying program now, it is perhaps not surprising that Executive Director Peter Praet specifically mentioned it as a possible future policy tool in an interview with The Wall Street Journal last week. With interest rates already at rock bottom and inflation well below target, two risks in particular loom large that could yet tempt the ECB to act.

The first comes from Italy, where dysfunctional politics have prevented any meaningful reform, even as government debt has risen to 130% of GDP. Many Italian business leaders now despair of the current coalition government, which appears more concerned with its own preservation than delivering any real change. Italy is the only Southern European country where all relevant measures of productivity and competitiveness have deteriorated since 2008. Unless a political consensus swiftly coalesces around a program for reform, the euro zone's third-biggest economy will continue to represent a significant risk to the recovery.

The second risk is external: The longer other countries persist with their aggressive stimulus policies, the stronger the euro remains, undermining the euro-zone recovery. Some European officials are privately scathing of what they regard as beggar-thy-neighbor money-printing by the U.S. and Japan. Indeed, this month's surprise ECB rate cut can be partly seen as a response to the unwelcome strength in the euro. The foreign-exchange market may yet be the battlefield on which the next phase of the euro crisis is played out.