Deflation, the euro and the banking union

by George Hatjoullis

An interesting article in the FT ( by Lorenzo Bini Smaghi  draws attention to the eurozone’s collective trade surplus at a time of increased demand for eurozone assets. He attributes this situation to the ‘strength’ of the euro. The parallel with the situation in Japan over the last 20 odd years is quite striking. Indeed he does not mention but alludes to another parallel; deflation. He suggests not sterilizing Security Market Purchases, though they might also need to grow to have much impact. The thrust of his argument is that there is a growing demand for euro balances which the ECB is unable to meet.

In some respects this might sound surprising given that the very existence of the euro has been in question in the last few years. The existential threat is deemed to have passed and the demand for euro is now a matter for economics, and not simply politics. The threat of deflation will of course increase this demand for euro balances and presumably the demand for the euro vis-a-vis other currencies. The parallel with the Japan experience is thus complete.

Deflation, as previous blogs have explained at length, is structurally negative inflation expectations. The logical behaviour in this environment is to hold fiat money or near money. The return to holding such money balances is the negative inflation rate plus any (normally positive) nominal interest rate paid. The only way to discourage holding such balances is to force nominal interest rates negative. However, this is quite difficult. Another way of looking at this is to note that in a deflation it is virtually impossible to force real interest rates into negative territory. If this sounds odd recall that expected inflation is negative by definition. This situation did prevail in Japan for a substantial period during which the Yen strengthened against most other currencies. Can this happen in the eurozone?

The implication of previous blogs is that it most certainly can. In a monetary union adjustment for competitiveness reasons occurs through wages and prices. If one dominant economy within the union insists on price stability within its national economic area, then the burden of adjustment falls on all other member states. This is the situation with the strongest economy, Germany, insisting on price stability in its region and forcing less competitive ‘partners’ to bear the whole burden of adjustment. Deflation is an inevitable result within the eurozone, possibly including Germany. A symmetric adjustment, with Germany accepting higher inflation for a period, would ease the burden and possibly avoid the deflation. However, this seems unlikely as Germany’s pathological fear of inflation and dominant economic position seem to dictate. The ECB is unable to print enough euros to meet the demand. The result may well be a situation not dissimilar to that of Japan in the last 20 or so years.

The other element is the banks. Japan banks remained broken throughout the deflation and were unable/unwilling to expand lending and hence create the necessary Yen balances to meet demand. The proposed banking union is trying to avoid this mistake by creating a healthy eurozone banking sector that will expand credit and create the euro balances that are in demand. If the banking union is not effective then the only hope of avoiding deflation is lost. Much more rests on a successful banking union than is widely understood. The conditions for an effective banking union have also been discussed at length in previous blogs. It is difficult to be optimistic.

Unlike Japan, however, the euro presents a conundrum. As long as the existential risk is ignored the euro may well tend to appreciate against other currencies as the deflation takes root. The difference is that Japan was , and is, a homogenous national entity that was unlikely to break up into sub-groups each with its own currency. The eurozone does not fulfill this criterion. The existential threat may return in a deflation which would undermine the currency. Tricky.