Is Deflation a Serious Risk for the Eurozone?

by George Hatjoullis

The simple answer is yes and has been explained in various blogs on Gestaltz. The Economics 1-18 series is particularly relevant. However, given the complexity of the issue and the strident denials from various authoritative sources it is worth revisiting with a specific focus on the eurozone.

First, what is deflation? It is not simply a condition of ex post falling prices, though this is involved. It is the expectation of falling prices that defines deflation. The expectation can be a powerful force even though actual measured price falls might not be dramatic. A strong fear of falling prices leads to a particular kind of behaviour that may be problematic, namely a strong demand for bank money and cash. If a bank deposit pays a positive nominal interest rate and prices are expected to fall, then holding bank deposits promises a return in terms of purchasing power (a real return) of the nominal rate of interest and the expected fall in prices. Hence the stronger is the fear of deflation the greater the desire to hold money wealth as bank money or the equivalent. Clearly, if actual price falls continuously fail to match fears this will impact future expectations. However, the important point is that fear of deflation is not simply a matter of observed price falls. Moreover, just as inflation expectations can become entrenched and difficult to change, so too deflation expectations can become structural and self-reinforcing.

Second, a particular problem in a deflation is that central bank power is asymmetric. It is easier to lead a horse away from water (so that it cannot drink) than to make it drink by taking it to water. It is up to the horse. Convoluted? The water in this case is the supply of bank money. One way to ease deflation expectations is to expand the supply of bank money. However, this is largely a matter for banks and their lending. If they do not wish to lend then the supply of bank money does not expand however much central bank money the CB creates. The power of CBs is much less than people appreciate and especially in a deflation. Anyone that doubts this should speak to the Bank of Japan. Once a deflation takes root it is hard to break. This is why the USA and UK acted with such vigour after the Lehman collapse. This is why the prevarication of the ECB is causing such concern. If a deflation takes root in the eurozone there is precious little the ECB can do.

The lessons of Japan, the USA and the UK are relevant to the eurozone. The UK has seen the measured inflation rate decline to the target rate after several years of vigorous monetary easing. This alone is cause for concern. The US is beginning to exit from the aggressive easing programme even though inflation remains unusually subdued. The Bank of Japan is expanding its balance sheet at an unprecedented rate and inflation is barely responding. The flow of funds out of emerging markets is forcing these fragile economies to push up interest rates. This is not a global inflation environment and the ECB needs to recognise this context.

The problems for the ECB are complex. It is true that the observed deflation in peripheral eurozone countries is part of the relative price adjustment that is necessary in lieu of exchange rate flexibility. However, the burden of price adjustment is being forced entirely onto these countries. The reason is that the strongest economy, Germany, refuses to allow any inflation within its own borders. The ghost of Weimar still haunts Germany in a pathological fear of inflation. The ECB would find its role more tractable if Berlin would allow Germany to experience above target inflation for a period. The relative price adjustment within the eurozone could thus be achieved without inflicting aggressively falling prices on the periphery. Germany is steadfast in its opposition to any such accommodation. Moreover, the degree of freedom of the ECB is severely limited by the Maastricht Treaty and all efforts by the ECB to gain some wiggle-room have been challenged by Berlin via its constitutional court. The latest challenge on the OMT programme is now with the European Court, having been referred by the German Constitutional Court. This is no way to run a monetary union when deflation is a possibility.

The problem is persuading the eurozone banks to lend. The constant pressure to raise capital and undergo stress tests is not helping in this respect. However, there is also evidently little demand for bank credit within the eurozone. The austerity measures are implicated. A well structured and transparent bank regulatory and support mechanism would help (banking union) but this is still evolving and early indications are that it resembles a dogs dinner. So the banks cannot be relied on to ‘stimulate’ the eurozone away from deflation however much liquidity is available and however low the ECB determined interest rate.

There is much talk in the press about the probability of a deflation. This is largely irrelevant. The probability is not the only consideration. The consequences must also be considered and the powerlessness of the central bank if deflation takes root. Even a 20% probability is too high when this is the situation so pre-emptive action by the ECB is essential (and it may already too late). Ironically, the only effective CB action if a deflation has taken root is deficit financing, and this is absolutely taboo everywhere. Given the parameters it will be pure luck if the eurozone is able to avoid a deflation taking root and the eurozone may have already exhausted its allocation of luck in getting this far.