Deflation and Disinflation in the eurozone
by George Hatjoullis
The ECB insists that its interest rate policy is to combat disinflation and that there is no deflation in the eurozone. It might help to define deflation before having this debate. I offer a definition of deflation in my blog Abeconomics, deflation and the Japan conundrum (http://bit.ly/WVnCVP) that might be helpful in grasping this debate.
Inflation and deflation are normally discussed in terms of ex post outcomes of various price indices. However, both are fundamentally ‘states of mind’. It is the expectation of inflation/deflation that does the economic work. Price index outcomes will feed back and effect these ‘states of mind’ or expectations but there is much more going on. Deflation might be defined as structurally negative inflation expectations. People fear falling prices even if actual price falls are not spectacular. The same applies in reverse to structurally positive inflation expectations.
Structurally negative inflation expectations bring a particular form of economic behaviour. People like to hold wealth in cash or near cash assets. The expected return is the negative inflation rate plus any nominal interest they might earn. Indeed if inflation expectations are structurally negative then the demand for fiat money continuously exceeds supply. This is why prices keep falling. There is a simple solution. Supply the fiat money that is demanded.
For Japan this is a relatively simple matter. There is one central bank and one economy which happens to coincide with the sovereign entity. Nevertheless, despite the conceptual simplicity, Japan has failed to resolve its deflation in the last 20 or so years and is only now getting to grips with problem. The eurozone is not even conceptually simple. There is one central bank and many, loosely connected, economies, each coinciding with a separate sovereign state. Inflation expectations differ widely throughout this unusual economic grouping. Moreover, there is one very important state in which deflation, as defined above, might never occur; Germany. The Weimar experience (and all that ensued from it) has permanently biased German expectations towards inflation.
This presents the ECB with an interesting dilemma. Imagine a situation in which Germany (and its satellites) have positive inflation expectations whilst the rest of the eurozone enters deflation. One part of the eurozone fears rising prices and the other part falling prices. One part of the eurozone seeks assets that protect against inflation and the other part seeks fiat money balances. One way of building up fiat money balances is of course to not spend or invest. Borrowing is also discouraged. This could become a structural feature of the deflation part of the eurozone. A logical response to positive inflation expectations is to spend and invest a little faster. Money balances are then run down to a minimum and debt levels pick up.
All the averages that the ECB uses to judge monetary conditions might look reasonable. However, the distribution around the mean would be a lot wider. Interestingly the situation looks superficially self-equilibriating. Aggregate debt would be falling in the deflationary economy and rising in the inflationary economy. This is desirable in the present situation. However, falling investment and spending in the deflation economy would hit employment and living standards and, in a single market, drive population and capital to the inflation part of the eurozone. The deflation economies would become depressed regions of the wider eurozone economy. In Japan the state partly offset the effects by increasing public spending and public debt. In the eurozone no sovereign state has this option. The centrifugal force of the currency union, much discussed in the 1970s, appears to be happening.
The situation is made worse by the asymmetric expectations of the German economy. Recall the definition of deflation above. It is a state of mind. If inflation expectations are entrenched, as they seem to be in Germany, then they persist even if prices are falling. It is this that makes the risk of deflation in the eurozone that much greater than it might have been. The largest and most powerful economy has permanent positive inflation expectations. This economy also has the greatest political power and will resist all attempts at a symmetric approach by the central bank. If Japan, a unitary homogenous entity, could not avoid deflation why does everyone feel so confident that this fractured political and economic structure will do so when it is dominated by a country with asymmetric and positive inflation expectations?
Why on earth does anyone want to be part of this…?