Deflation and Monetary Expansion in the Eurozone

The current annual rate of inflation in the eurozone is 0.1 per cent, and the core inflation rate is about one per cent. Seven member states experience some deflation.There is nothing wrong with that.

In 1967, Milton Friedman, Harry Johnson and Paul Samuelson independently published papers arguing that, since the marginal cost of producing money is close to zero, the opportunity cost of holding money rather than securities should also be close to zero. This requires moderate deflation – of course, not 6 to 7 per cent per annum as in the Great Depression  but one or two per cent. That is exactly what the seven deflating eurozone countries are experiencing now.

Deflation in these countries (notably Italy, Spain and Cyprus) is required to restore their competitiveness because in a currency union competitiveness cannot be regained by devaluation. In a currency union, competitiveness can only be restored by lowering prices. This can be quite costly as we are witnessing.

Deflation does not have to be associated with low growth and high unemployment. Take Switzerland as an example.. Since 2010, Switzerland has had a compound average rate of CPI deflation of 0.4 per cent. Over the same time span, average growth of real GDP has been 1.5 per cent, and the average rate of unemployment has been merely 4.3 per cent. That is also the current unemployment rate. Thus, deflation is not the cause of low growth and high unemployment in the eurozone.

In 1999, the European Central Bank announced an inflation target of zero to two per cent. In May 2003 it raised its inflation target to 1.9… (which is of course a joke). That was a mistake. Indeed, the definition of price level stability should not have been left to the central bank at all. An independent bureaucracy should not be entitled to define its own objectives.

Turning to the ECB’s monetary policy, we note that its rate of monetary expansion for M3 has been exceeding its reference rate of 4.5 per cent per annum since the spring of last year. There was no good reason to lower interest rates since then. The current refinancing rate is also lower than predicted or required by the Taylor rate.The economic problems of the eurozone are not due to excessive interest rates, and they cannot be solved by hyperexpansionary monetary policy.

Nor can they be solved by government deficit spending. As monetary policy is loose there is no need for deficit spending. In the current situation, deficit spending is even counterproductive. For if the deflating countries maintain high budget deficits, they obstruct the the lowering of their price level which they need to restore their competitiveness and attract foreign investors. A budget deficit causes a real appreciation. The problem of these eurozone countries is that there is too little private investment because labour markets are not functioning well, because expected profits are too low and because banks are undercapitalized. These eurozone countries have a supply-side problem – they need courageous supply-side reforms.

I do not object to quantitative easing. There is nothing wrong with a central bank purchasing securities – especially when interest rates are already low and when banks do not borrow enough central bank money. However, quantitative easing should not be abused to finance government deficits – the more so as this is prohibited by the treaties. Moreover, by financing government deficits, the ECB is relieving the governments of the pressure to undertake the required supply-side reforms.

In the first five years of its bond purchases, the ECB exclusively purchased bonds issued by overindebted governments of the eurozone. That was illegal monetary budget financing, and it is a shame that the Court of Justice of the EU has refused to say so.  Since last year, the ECB has been buying a broader portfolio of securities including corporate bonds and asset-backed securities. I have always argued that the ECB ought to buy a representative portfolio of securities so that it does not distort the allocation of capital by discriminating among borrowers. In September 2013, a group of 150 German professors of economics agreed on this demand in a manifesto.

Unfortunately, we do not know whether the ECB is buying a representative portfolio or not. We do not know the extent to which the ECB buys low-quality ABS from ailing banks and low-quality bonds from ailing governments. We do not know whether and to what extent it is abusing quantitative easing for political  purposes. This has to be changed. A few days ago, some national central banks have published information about the corporate bonds which they have bought. But the picture is incomplete. The Eurosystem ought to publish the precise amount of each security it has bought and group all its securities by type of issuer and maturity. Any private investment fund is obliged to publish its portfolio. The best protection against abuse is transparency.

Many economists believe that the current fuss about trivial deflation is merely a pretext for monetary financing of government budgets and of ailing banks. The test will come when inflation and growth (as a predictor of inflation) pick up. Will the ECB raise interest rates in time and enough? There is a widespread fear that it will not – that it will yield to pressure  from politicians and bankers. I share this concern.

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