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Europe Should Use its Last QE Bullet Wisely

Jean-Michel Paul is founder and Chief Executive of Acheron Capital in London.
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Recent reports by the European Central Bank paint a picture of two Europes divided by a single currency. The first grouping is composed of highly indebted countries, chief among them Italy and France. The second, led by Germany, is the Europe of fiscally conservative countries.

QuickTake Europe's QE Quandary

The former support additional quantitative easing to keep national budgets from ballooning. The latter have accepted the recent splurge of ECB-authorized bond-buying through gritted teeth and may be running out of patience. Both groups need to find a compromise.

My proposal is to use quantitative easing differently. Rather than a policy that risks inflating financial bubbles and subsidizes bad fiscal behavior, money created by QE could be funding Europe's future directly by being channeled into a Europe-wide infrastructure investment fund. Europe already has a vehicle (albeit underfunded) for this; explicitly linking money creation with investment would provide proper resources to boost growth and remove the temptation for less productive expenditure.

Infrastructure spending in the euro zone has dropped to an average of 2.7 percent of gross domestic product, compared with 3.4 percent of GDP for the U.S. and 3.6 percent for Japan. The larger countries -- France, Italy and Germany -- have reduced investments by between 15 to 20 percent in the past two decades.

As the European Commission noted in its July statement on the creation of its infrastructure fund:

Weak investment in the euro area has a considerable impact on the capital stock, which in turn holds back Europe's growth potential, productivity, employment levels and job creation.

What the Commission did not underscore was how the most indebted governments chose to spend their money during this period: social expenditure. According to the European Commission database, Italy increased social expenditures by more than 6 percent of GDP and France by close to 4 percent. Italy essentially spent all of its savings on interest-rate costs -- and France's government a multiple of its -- on social programs, chief among them pensions and health. In 2012, pension expenditure accounted for 15.8 percent of GDP in Italy and 13.8 percent in France, compared to an average of 7.9 percent among members of the Organization for Economic Cooperation and Development. During the same period, Germany reduced social expenses by 0.5 percent of GDP, which came on top of its interest-rate savings:

Source: European Commission

That this should happen is critical to understanding the current conflict within the ECB. The euro was billed as heralding a new era in which Europe's more profligate members would accept German fiscal orthodoxy, enshrined in the Maastricht criteria. The Maastricht straitjacket would encourage fiscally prudent behavior while lowered interest rates would allow for reduced national debts and renewed infrastructure investment.

The subsequent promised drop and convergence in government borrowing costs in the bond market delivered material savings for budgets across the euro zone, including Germany's. According to the Commission, debt-servicing costs for Germany are down to 1.5 percent of GDP today, from 3.4 percent 20 years ago, a savings of close to 2 percent of GDP. French government interest payments dropped by 1.3 percentage points to 2 percent of GDP, while Italy's burden is down to 4.2 percent from 11.1 percent. 

In short, European states benefited from a prolonged decline in interest rates similar in magnitude to what QE has delivered. But while some countries were realizing big savings through reduced borrowing costs, they were simultaneously reducing investment and increasing vote-winning social spending.

Having failed to save and invest in the good times, euro zone governments borrowed heavily when the financial crisis hit. Italy's debt-to-GDP ratio now stands at 130 percent; Portugal's is similar and France's is more than 95 percent. With debt and deficit levels already dangerously high, these nations have no room for maneuver on the fiscal front. 

If this tells us anything it is that indebted countries are desperate for the benefits of QE, but will misuse it, while potentially creating financial bubbles in conservative ones. Investing in European infrastructure and research is a much better use of the proceeds of this seigniorage.

A recent International Monetary Fund study concluded that in advanced economies, increasing infrastructure investment by 1 percent of GDP boosts short-term output by between 0.4 percent and by 1.5 percent in the following four years. In a period of anemic demand, this is significant. Further, it means that the economic output is raised without an increase in the debt-to-GDP ratio. While the Commission seems to recognize this, the resources Europe is committing to infrastructure and research continue to be wholly inadequate. The European Investment Bank and EC were only able to gather a paltry 16 billion euros ($17 billion) to establish the European Fund for Strategic Investment (EFSI). It will take much more to meet the Commission's goal to "break the vicious circle of under-confidence and under-investment, and to make use of liquidity held by financial institutions, corporations and individuals at a time when public resources are scarce."

Whether spent on roads, high-speed rail or even ensuring that all EU citizens have fast internet access, there are plenty of potential projects to compete for these resources. If the IMF is correct, they will generate, on average, more output than they would cost. And in due time, some can be privatized. 

The euro zone is at a cross-roads.  Structurally badly designed, weakened through wide-scale fudging of the entry criteria, it has subsidized bad behavior. It is now becoming overly reliant on aggressive monetary policy, with the ECB unfairly left as the only economic policy engine. The risks are only beginning to be discussed. The least that can be done is to spend the QE money wisely.

(Corrects eighth paragraph to show that German debt servicing costs were reduced by close to 2 percent of GDP, not 4 percent.)

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Jean-Michel Paul at JPaul@acheroncapital.com

To contact the editor responsible for this story:
Therese Raphael at traphael4@bloomberg.net