Mario Draghi was sure back in August 2013: “We see no deflation in the euro zone,” said the president of the European Central Bank (ECB).
The main reason for his certainty wasn’t necessarily the numbers, which already then showed prices falling in some euro zone countries, even if prices were positive on average. The reason was Mr. Draghi’s definition of deflation, as a sustainable, self-reinforcing decline in prices that causes consumers and investors to put off their purchases in the expectation of even lower prices in future.
Nevertheless, over the following 13 months, Mr. Draghi and the ECB’s Governing Council, its key decision-making board, shifted their stance and agreed to a series of comprehensive measures to guard against the risk of deflation. In doing so the ECB, largely unnoticed, has changed its theory and pivoted to becoming a deflation-fighting protagonist.
This shift over how to tackle deflation goes to the heart of the debate over how to deal with the euro zone’s ongoing economic crisis. Some economists have argued that a bout of deflation is not such a bad thing – many southern European countries in particular saw prices rise too sharply in the decade before the 2008 financial crisis. The ECB, however, is arguing that deflation is something that must be prevented at all costs.
Back in August 2013, the ECB’s task was simply a matter of keeping the inflation expectations “firmly anchored,” because this would preclude the deflationary spiral feared by Mr. Draghi. But in the following months, Mr. Draghi came to realize that the dangers of a sustained fall in prices go beyond merely causing a wait-and-see attitude among consumers. That is because there are many other more important hidden aspects, such as the effect on those in debt – whether the public or governments – who will suddenly face a higher bill to pay back.
In addition, the theory behind the presumed effect of deflation on the consumer is not especially sound. “Our results show that the widely-held fears of negative effects of deflation on consumption have a weak basis,” according to a study released in July by the Kiel Institute for the World Economy (IfW).
The deflation theory originally came from James Tobin, a Nobel Prize winner in economics. “If you expect falling prices, you will postpone purchases, preferring to hold money rather than buy goods,” Tobin wrote.
That’s because putting money under a mattress, or leaving it languishing in a checking account, still brings you a nominal interest rate of zero. If prices fall by 2 percent per year, that corresponds to a real interest rate of 2 percent. That is as the same as the bank giving you 2 percent interest on your money when prices are stable.
IfW economists think they have disproved Tobin’s theory. They looked at goods where prices are expected to fall over the long term, such as digital cameras, and reported no consumer caution in their buying habits.
“The widely-held fears of negative effects of deflation on consumption have a weak basis.”
But the counter-argument of the Kiel economists does not necessarily stick. That’s because if some goods get cheaper, but prices rise on average, then cash doesn’t bring a positive real interest rate. Holding money along Mr. Tobin’s lines would not be worth it.
Nevertheless, doubt has been cast on whether or not getting 2 percent real interest on your money really misleads people in large numbers to change their lifestyles and live below their means. Ultimately, getting 2 percent interest is also achievable in normal times with relatively secure investments.
At a speech at the annual gathering of central bankers in Jackson Hole, Wyoming, in August, Mr. Draghi famously changed the preliminary text of his speech. His prepared remarks spoke about ensuring that inflation expectations are well-anchored. When he actually spoke, he changed that passage on the spot and instead spoke about how the ECB would do everything to reach its inflation target of almost 2 percent. He stressed that a long period of low inflation already presented a problem. Thus, the fact that inflation was below expectations was itself not the point.
Mr. Draghi can refer to Irving Fisher, who in 1933 drew the lessons from the Great Depression at that time and developed a theory on debt deflation. In his theory, he took an inflation rate where the actual value of an investor’s debts decreased each year. If inflation remains under expectations for a longer period of time, the indebtedness of many turns out to be subsequently too high.
What happens? These debtors try to lower their debts and spend less money. If that happens on a large-scale, then demand drops and with it so does the income from which the debts are serviced. At the same time, the money supply contracts as liabilities are paid off. The downward pressure on prices increases. If many debtors fail to carry their ever-increasing debt burden, then there are more defaults and the banks have a problem on their hands. This kind of negative spiral can already be observed in some of the euro zone countries in crisis.
The debt deflation has an especially strong effect if the indebtedness of businesses and households is high relative to the economic performance, as was the case before the Great Depression and before the breakout of the current financial crisis.
The former chairman of the U.S. Federal Reserve, Ben Bernanke, warned in 1999 in looking at Japan’s battle with deflation that zero inflation in the context of the high indebtedness at the time was much more dangerous than it had been in prior periods. The highly indebted companies in Portugal, Spain, Greece and Cyprus and the not so highly indebted in Italy could write a book about that.
If one factors in the influence of rising indirect taxes, then the prices that are passed on to consumers have dropped in the past 12 months by about a half a percent, compared to ECB’s inflation target of 2 percent. Calculating with this target rate, their debt servicing relative to income is two-and-a-half percentage points higher than thought – a rapidly growing and dangerous trend.
Norbert Häring covers monetary policy and the European Central Bank for Handelsblatt from Frankfurt. To contact the author: email@example.com.