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Deflating Europe: Is the European Central Bank finally ready to do its job?

March 28, 2014: 11:13 AM ET

Plagued by the persistent threat of deflation, the European Central Bank is considering bringing out the big guns.

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FORTUNE -- If you thought central banks around the world were finally ready to give their printing presses a rest, think again.

In interviews this week with the Wall Street Journal, central bankers from Germany and Finland said that they would be open to the possibility to more aggressive monetary policy, including a full-blown quantitative easing program like the one the U.S. Federal Reserve is in the process of winding down.

The Fed launched its first round of quantitative easing way back in 2008. Since around that time, Europe has been dealing with an ongoing debt crisis. So why are the Europeans just now talking about these measures? A few reasons:

  1. 1. Unlike the Fed, the European Central Bank has a single mandate: Keep prices stable. Since the Fed is also tasked by Congress with maximizing employment, it had a much greater motivation to resort to unconventional ways to stimulate the economy;
  2. 2. The ECB is actually struggling to "keep prices stable." The thing is, the European Union is in danger of failing on the side of deflation; and
  3. 3. The American bond-buying program, which has successfully kept down long-term interest rates and has likely been at least a small boon to economic growth, has not lead to inflation as critics had feared.

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Reasons 1 and 3 give the EU cover to pursue quantitative easing as a cure for 2. Even a little deflation is viewed by some economists as potentially worse than high inflation. Indeed this view is the official perspective in much of the world, as most central banks have explicit policy goals of maintaining yearly positive inflation of 1% or 2%.

What's so bad about deflation, you ask? Just as with inflation, there are good and bad varieties. In the case of inflation, if prices are rising rapidly because of the normal dynamics of supply and demand, well, that's just capitalism. But if prices are rising because of poor management of the money supply, that's a potentially destabilizing and self-enforcing crisis. The same goes for deflation: Prices fall all the time because of increases in productivity, and that's a sign of economic progress. But sometimes deflation attacks simply because in a weak economy, people become risk-averse. They stop spending money, causing prices to fall. This dynamic of falling prices hurts debtors, who have borrowed money at one price level, and are now seeing their incomes fall but their debt levels remain the same. And this dynamic can cause a series of defaults, which only makes the situation worse.

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The European Central Bank certainly doesn't want to see this situation occur, and so officials, even hawkish ones like Jens Weidmann, the German Bundesbank president, are saying that a European QE is a possibility.

Doesn't the EU already have a bond buying program of its own? Yes, to help quell the European debt crisis, the central bank began buying bonds of the weaker European economies, but unlike the U.S., it "sterilized" those purchases by selling other assets at the same time to keep the overall level of money in the system level. A full-scale quantitative easing program would forgo this step.

But hawks like Weidmann are quick to point out that a QE program might be considered illegal according to EU law, which bans so-called debt monetization, whereby government spending is financed by central bank money-printing. This is the sort of thing that has accompanied various episodes of hyperinflation from Germany in the 1930s to Argentina in the the 1980s. The problem with this phobia is that monetization is a symptom of hyperinflation rather than the cause. As Matthew O'Brien at The Atlantic has convincingly argued, hyperinflation is really triggered by some sort of exogenous calamity, like natural disasters or war, which destroys an economy's productive capabilities. It's when governments try to step in to repair this damage and rebuild the economy with printing and borrowing that hyperinflation really takes hold.

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In fact, debt monetization is really just another word for the job of central banks. Central banks buy and sell government debt all the time in order to effect the right level of money in the system, depending on the economic conditions on the ground. And if you're worried about the wrong kind of deflation, there's not enough money in the system. And it's looking like the European Central bank might finally be realizing this is the case.

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