Ignoring Reality

The ECB’s Fallacy

Germany European Banking Congress
Don't be so hard-nosed, Mr. Draghi. Source: AP

Each generation tends to perceive the range of interest rates with which it grew up as normal, American economists Sidney Homer and Richard Sylla wrote in their classic work “A History of Interest Rates.” By historical standards, however, negative interest rates are everything but normal, because they did not exist until a few years ago. So how valid are the arguments in favor of negative interest rates?

The European Central Bank (ECB) has a target inflation rate of “below, but close to, 2 percent over the medium term,” which it defines as price stability. This raises the question of where this 2-percent target and definition of price stability come from.

The deflation of the Great Depression plays a special role in the ECB’s argumentation. According to the ECB, it is imperative that prices do not begin to decline, because this could lead to the same sort of vicious circle that plagued the Great Depression. But this argument overlooks the fact that not every period of falling prices has to end in a crisis. For instance, the trend toward falling prices between the end of the American Civil War and the end of the 19th century was accompanied by strong economic growth.

The 2-percent inflation target cannot be justified with the argument of deflation nor with the growth argument, with respect to creeping inflation.

The Great Depression came about under the unique conditions of debt-financed, excessive speculation and the severance of trade relations due to trade barriers. These aberrations led to deflation, that is, to declining prices combined with extremely high unemployment rather than declining prices per se.

Due to the lack of competition after World War II, the trade barriers from the Great Depression led to a new type of inflation called creeping inflation. This is when the 2-percent inflation target emerged. When there is a lack of competition, the prices of individual goods do not decline. On the other hand, prices have to adjust to one another, with less desired goods becoming cheaper than goods that are more in demand. This works best with rigid prices, when the rate of inflation is around 2 percent. If the central bank were to strive for stable prices on average in this situation, it would be attempting the impossible, namely that the prices of less desired goods decline, harming economic growth in the process.

All of this applies to a situation in which there is insufficient competition, but that situation no longer applies. Global competition is extremely intense, and there is downward flexibility in the prices of individual goods once again. Hence, the 2-percent inflation target cannot be justified with the argument of deflation nor with the growth argument, with respect to creeping inflation.


To reach the author: gastautor@handelsblatt.com

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