Will European Deflation lead to More Stimulus

By Anthony Jerdine  March 18, 2016

Eurozone central planners officially target a 2.0% annual inflation rate, but they failed to hit that mark in 2013, 2014 or 2015. This is a problem, at least according to many prominent Eurozone economists, because it highlights the risk of deflation in the region. To these economists, most of whom follow the policy teachings of John Maynard Keynes, the threat of deflation trumps nearly every other macroeconomic concern.

Deflation is a monetary phenomenon where the general price level in an economy declines. The value of a currency increases during deflationary periods when the money supply shrinks or when increases in productivity outpace its growth. Consumers see falling prices, and workers see an increase in the purchasing power of their wages.

Keynesian thinkers warn that deflation causes consumers to save too much and spend too little, slowing economic growth and threatening a downward spiral. Most are willing to print seemingly unlimited sums of money to avoid that result.

“The risks of acting too late outweigh the risks of acting too early,” Mario Draghi, the president of the European Central Bank (ECB), told an audience at a conference in Germany on Feb. 4, 2016. He was trying to rally support among a German population fatigued by years of unsuccessful stimulus plans.

The Theory Behind Deflation and Stimulus
Deflation seems beneficial to the economy at first glance. Declining prices allow individuals, especially the poor and those on fixed incomes, to enjoy higher standards of living. Indeed, some economists argue that a little deflation is normal and healthy, not destructive. However, to Keynesians such as Draghi, declining prices invoke the Paradox of Thrift, which states that lower prices cause less spending, which means less business revenue and slumping profits. They argue this has the potential to lead to a recession.

When Draghi was pressed in October 2014 about why higher prices would help Europeans, the central banker responded: “I’ve said many times, the recovery is weak, fragile, uneven, and still is, so the hope is that when we see some price pressure, some price power, back in the economy, at the same time, we would also like to see some strengthening in the economy.”

Major central banks try to avoid deflation through easy monetary policy. Easy monetary policy is supposed to raise prices, lower interest rates and discourage saving to make borrowing and spending more attractive. For those who believe spending is the engine of economic growth, as the Keynesians do, this is the obvious solution.

The Evidence of Past Efforts
The Federal Reserve, ECB and Bank of Japan all responded to the threat of deflation in 2008 and 2009 by buying toxic assets, which flooded capital markets with cheap money and lowered interest rates.

Currency devaluation and easy-money efforts date back more than a century and have mixed results. The Fed’s own quantitative easing programs were underwhelming in the United States, and the Federal Open Market Committee opted to raise target rates in December 2015. Japan has been mired in a low-interest-rate regime since the late 1980s, and has virtually zero growth over that period to show for it. The ECB acted less swiftly and less dramatically than its Japanese and American contemporaries, something European doves point to as a reason for the region’s tepid recovery from the Great Recession.

The Eurozone’s and Japan’s gross domestic products (GDPs) are still well below 2008 levels. The United States, by contrast, added more than $2.5 trillion to its GDP between 2008 and 2015. It is possible that friendlier business conditions and a general faith in the US. dollar are responsible for this difference, rather than varying levels of monetary stimulus.

In December 2015, the ECB announced more aggressive bond purchases, slashed its deposit rate from 0.1% to -0.3% and extended its stimulus program a potentially indefinite length of time. The president of Germany’s Bundesbank, Jens Weidmann, strongly dissented and argued against extra stimulus, arguing that it harms price stability.

What Comes Next
According to ECB data, consumer prices fell by 0.2% in February, probably because energy prices were very low. It was the region’s first calculated deflation since September 2015.

Inflation in the Eurozone was below 0.5% on a monthly basis every month between July 2014 and February 2016. The most direct way to push prices up even further is to devalue the euro. The ECB can most easily devalue the euro through a more pronounced asset-buying program and throwing even more cheap money at European capital markets. In other words, the ECB can make it uneconomical to hold on to euros.

The ECB has a scheduled policy meeting on March 10, 2016. The return of deflation should spark lively debates between hawks and doves on another stimulus round. Draghi seems firmly committed to fighting deflation, and the ECB has a majority of Keynesians. Expect future stimulus programs in Europe and added downward pressure on the euro.

Will European Deflation Lead to More Stimulus?


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