The eurozone is in a dreadful mess. The currency area’s economy is stagnating: It grew by only
0.8 percent in the year to the third quarter of 2014 and remains 2 percent smaller than in
early 2008. The unemployment rate is 11.5 percent. Deflation looms: prices fell by 0.2 percent in the
year to December.

That last fact looks set to prompt the European Central Bank (ECB) to embark on a program of
quantitative easing (QE) at its next meeting on Jan. 22. Since official interest rates are at zero and can
scarcely fall further, ECB President Mario Draghi is counting on unconventional monetary policy to
boost the economy and lift inflation back towards its target of “below, but close to, 2 percent.” While
the ECB has already bought some private-sector assets, it is now expected to start purchasing large
quantities of government bonds with freshly created money. But while nothing has been officially
decided yet, German opposition is such that QE is unlikely to be big and bold enough to stave off
deflation – and the easing may do more harm than good.

Deflation would be disastrous for the debt-laden eurozone. Optimists point out that the fall in the price
level is partly due to the collapsing prices of commodities, notably oil, which makes net consumers
such as the eurozone better off. That’s true, but the eurozone economy is so weak that this one-off price
fall is already leading businesses to slash wage offers, entrenching its deflationary impact.
Since inflation (excluding energy prices) is only 0.6 percent in the eurozone, deflationary pressures are
mostly a symptom of debt-depressed demand, which in turn exacerbate the problem. The prospect of
lower future prices deters companies from investing. And since nominal interest rates cannot go lower
than zero, falling prices push up real borrowing costs, further denting investment while making
existing debts harder to bear. That’s calamitous for a Spanish homeowner tied to a big mortgage in
negative equity and, likewise, for many governments trying to get a grip on their mountains of debt.

Once deflationary expectations become entrenched, they are extremely difficult to shift, as Japan’s
experience over the past two decades shows. So the ECB needs to credibly commit to do “whatever it
takes” to bring inflation back up to 2 percent.

Ideally, Draghi would “helicopter drop” cash to eurozone citizens, in effect, creating money and sending everyone a big enough check to get growth humming
and inflation back on target. (To similar effect, it could finance a big increase in government spending
with central-bank cash.) But the EU treaties and German monetary taboos preclude that.
The German policy establishment, including the Bundesbank, Chancellor Angela Merkel’s
administration, and the German Constitutional Court, is implacably opposed to QE. Among other
things, the Germans fear that if, for instance, the ECB starts buying lots of Italian government bonds, it
will take the pressure off Rome to reform and put its public finances in order. They reason that this
could eventually put the ECB in an impossible position: keep buying the bonds of a by-then-insolvent
Italy or precipitate a default in a 2.1-trillion-euro bond market — the eurozone’s biggest — that may
impose hefty losses on the ECB’s shareholders, not least the German government, and doubtless
shatter the euro. Moreover, Germany’s Constitutional Court objects to open-ended ECB commitments
that may entail open-ended losses for German taxpayers. Since Draghi dare not offend Germany too
much, any QE program will be limited and hedged with conditions.

Many aspects of the proposed QE program remain unclear, including when purchases will begin, how
much of which bonds will be bought, and on what terms. One thorny issue is Greece. Three days after
the ECB’s Jan. 22 meeting, Syriza, a radical-left party that wants to end austerity and renegotiate the
debts Greece owes eurozone governments, is expected to win the Greek elections. Although Syriza does
not want to restructure the market-traded bonds that the ECB might buy, Athens would be forced to
default if it was ejected from the euro. And including Greek bonds in QE would make it easier for a
Syriza government to borrow from markets, strengthening its hand in debt-relief negotiations with its
creditors. Excluding Greek bonds, though, would preempt the election outcome and revive speculation
of a Greek exit from the euro.

Hence the case for a delay — at least until the ECB’s meeting in March. But the Greek drama is unlikely
to be resolved by then. And a similar predicament arises in Spain, where Podemos, a radical-left party
that wants to audit and potentially restructure Spain’s debt, is leading in the polls ahead of elections
due by year-end. So a delay could become indefinite. The longer the ECB waits, the more deflationary
expectations are likely to become entrenched. So the ECB is likely to take the plunge, while perhaps
postponing Greek bond purchases and trying to insulate itself from the risk of a Greek default.

The next issue is the size of the program. Markets will be disappointed with anything less than 500
billion euros. Sovereign bond markets in the eurozone (except Greece) have already rallied massively
over the past year in anticipation of QE. For example, Italy, with public debt of 133 percent of GDP and
rising, can now borrow for three years for a mere 0.56 percent, down from 1.47 percent a year earlier,
and for 10 years for only 1.67 percent, down from 3.83 percent on Jan. 21, 2014. Since QE seems largely
priced in, markets could sell off if the figure is less than 500 billion euros. But while that sounds huge,
it would only partly reverse the 1 trillion euro shrinkage of the ECB’s balance sheet over the past two
years. And it is a mere 7.4 percent of the 6.8 trillion euros of governments bonds outstanding across the
19-country currency union.

A third issue is how much of which bonds to buy. Unlike the United States, which began its own QE
program in 2008, the eurozone lacks federally issued Treasury bonds, so the ECB must decide which
member governments’ bonds to buy. Since deflationary pressures are strongest in struggling southern
Europe, solely buying Spanish, Italian, and Portuguese bonds might be most effective, but that would
infuriate the Germans. Short of that, buying in proportion to the size of each government’s bond
market would tilt purchases towards southerners with bigger debts.

At the other extreme, the ECB could buy only the safest, triple-A-rated government bonds, primarily
Germany’s. But that would be perverse, since Germany needs QE least, and it would spark a sell-off of
southern European bonds. And by signalling that it thought southern European bonds weren’t safe, the
ECB would spook investors. So, in the end, the ECB will probably buy bonds in proportion to eurozone
governments’ capital contributions, where Germany weighs heaviest but southern Europeans still get
their fair share.

The most controversial issue for the Germans is how to handle the risk of a government defaulting on
bonds bought by the ECB. The ECB insists that such a default would be illegal, since it would be
“monetary financing” — central-bank financing of government borrowing — which the EU Treaties
forbid. But if it did happen, it would be embarrassing for central bankers who jealously guard their
independence — and Germans fear it would entail hefty losses for them. So the ECB looks set to insist
that each country’s central bank — for instance, the Bank of Italy — bear the risk of losses on their own
government’s bonds individually.

But Guntram Wolff of Bruegel, a Brussels-based think tank, argues that this would either undermine
QE’s effectiveness (because ECB buying would make Italy’s other bondholders more exposed to a
default) or fail to protect the ECB against loss. Worse, it would signal that the eurozone was no longer a
genuine currency union with a single monetary policy, in which central bank operations inevitably
have distributional consequences. That could revive concerns about Germany’s commitment to the
euro’s survival.

Yet the German fears are misconceived. As Paul de Grauwe of the London School of Economics points
out, it would make no fiscal difference to Germany whether Italy defaults on bonds purchased by the
ECB if any debt-servicing payments that the Italian government makes (or not) to the ECB are in any
case remitted to it (or not). To put it differently, since monetized debt costs Italy nothing, why default
on it?

Since QE is likely to be too little, too late to stave off deflation — and could even make matters much
worse — is it really the best way forward? After all, big and bold QE programs have had mixed results in
the United States, Britain, and Japan. They have artificially inflated asset prices, but scarcely
encouraged consumers to spend or businesses to invest. Arguably, QE encourages financial
speculation at the expense of business investment. Why venture new investment in a weak economy,
when there is easy money to be made from financial engineering? Besides, zombie banks don’t want to
lend to new borrowers.

On the plus side, QE has lowered governments’ borrowing costs, by pushing down longer-term interest
rates and because interest on bonds purchased by the central bank reverts to the government. Had
governments used this leeway for fiscal stimulus, QE might have been more effective in boosting
growth. Unfortunately, EU rules and German dogma preclude a fiscal boost in the eurozone.

QE may have its biggest impact on growth and inflation by weakening the currency, making exports
cheaper and imports pricier. On Jan. 15, in anticipation of the start of the ECB’s QE, Switzerland
abandoned its efforts to limit its currency’s rise against the euro, causing the Swiss franc to soar and
the euro to plunge. The trade-weighted euro has fallen by 5.5 percent over the past month, leaving it 8.2
percent weaker than a year ago — perversely, since the eurozone already has the largest (almost
entirely German) current-account surplus in the world. In a world of depressed demand, competitive
devaluation is a zero-sum game — and invites protectionism.

Ultimately, the reason why the eurozone is stagnating and sinking into deflation is that it is depressed
by excessive debt. Since the mutual monetization of debts by the ECB is politically unacceptable, the
eurozone needs to move forward with debt restructuring. Instead of wasting political capital enraging
the Germans with half-hearted QE, efforts should focus on the need for a debt conference to relieve
public debt, along with wholesale restructuring of private debts on zombie banks’ balance sheets.