The ECB is engaging in a new form of monetary policy by directly buying government bonds from Italy and Spain. The goal is to lower interest rates on bonds from these countries to reassure investors and reduce upward pressure on Eurozone rates. This quantitative easing should bring down borrowing costs for governments and the private sector, encouraging more spending and moving the economy closer to full employment. While this could increase inflation in some cases, Europe currently has excess capacity so growth is unlikely to cause inflation. The ECB's actions aim to prevent crowding out of private spending from large deficits and keep rates low until private sector confidence and spending recover fully.

1. Commentary:
The European Central Bank (ECB) is engaging in a new form of monetary
policy in which it buys government bonds directly from the Spanish and Italian
governments. Essentially, the goal is to bring down the interest rates on Italian and
Spanish government bonds, which should reassure private investors that Italy and
Spain will be able to pay them back and thus reduce the upward pressure on
interest rates in the Eurozone, a situation which threatens to reverse the already
sluggish recovery from the recessions of 2008 and 2009.
Monetary policy refers to a central bank’s manipulation of the money supply
and interest rates, aimed at either increasing interest rates (contractionary
monetary policy) or reducing interest rates (expansionary monetary policy). The
ECB is currently buying government bonds from European governments, effectively
increasing the supply of money in Europe with the hope that more government and
private sector spending will move the Eurozone economy closer to its full
employment level of output, at which workers, land and capital resources are fully
employed towards the production of goods and services.
If successful, the ECB’s “quantitative easing”, as the new type of monetary
policy is known, should bring down interest rates on government bonds and
thereby reallocate loanable funds towards Italy and Spain’s public and private
sectors. The increase in supply of loanable funds should bring down the private
interest rates available to borrows (businesses and households), making private
investment more attractive.

2. The ECB’s bond purchases make it cheaper for Italy and Spain to borrow,
lowering the interest rates on their bonds, restoring confidence among international
investors, who may be more willing to save their money in Italy in Spain. The inflow
of loanable funds into these economies (seen as an increase in the supply of loanable
funds from S1 to S2) should bring down private borrowing costs (the real interest
rate), encouraging more firms to invest in capital and more households to finance
the consumption of durable goods, increasing aggregate demand and moving the
Eurozone economy back towards its full employment level of output, from AD1 to
AD2 in the graph on the right.
In certain circumstances, monetary easing like this could be inflationary, but
in reality inflation is unlikely to occur given the large output gap in Europe at
present (represented above as the distance between Y1 and the dotted line,
signifying the full employment level of output). Any increase in aggregate demand
will lead to economic growth (an increase in output), but little or no inflation due to
the excess capacity of unemployed labor, land and capital resources in the European
economy today.
With private sector borrowing costs increasing due to growing uncertainty
over their deficits and debts, the Italian and Spanish governments will find
expansionary fiscal policies (tax cuts and increased government expenditures) are
unrealistic options for achieving the goal of full employment. The ECB, however, as

3. Krugman argues, should continue to play an increasing role in the expansion of
credit to cash strapped European governments, with the aim of keeping interest
rates low to prevent the crowding-out of private spending that often occurs in the
face of large budget deficits. Inflation, always a concern for central bankers, should
be a low priority in Europe’s current recessionary environment. Only when
consumer and investor confidence is restored, a condition that requires low
borrowing costs, will private sector spending resume and the Euro economies can
begin creating jobs and increasing their output again.
In the short-term, Italy and Spain should take advantage of the ECB’s bond-
buying initiative, and make meaningful, productivity-enhancing investments in
infrastructure, education and job training. If their economies are to grow in the
future, Eurozone countries must become more competitive with the rapidly
expanding economies of Asia, Eastern Europe, and elsewhere in the developing
world.
In the medium-term, the Eurozone countries must demonstrate a
commitment to fiscal restraint and more balanced budgets. Eliminating loopholes
that allow businesses and wealthy individuals to avoid paying taxes, for example, is
of utmost importance. Also, increasing the retirement age, downsizing some of the
more generous social welfare programs and increasing marginal tax rates on the
highest income earners would all send the message to investors that these countries
are commited to fiscal discipline. Then, in time, their dependence on ECB lending
will decline and private lenders will once again be willing to buy Eurozone
government bonds at lower interest rates, allowing for continued growth in the
private sector.