04/23/2014 06:18 PM

Weapon of Last Resort

ECB Considers Possible Deflation Measures

By Christian Reiermann and Anne Seith

A market in Oviedo, Spain. Is Europe threatened by falling prices?

Though the European Central Bank continues to play down deflation concerns, it is preparing measures to combat falling prices in the event of an emergency. Are the growing fears warranted?
One of European Central Bank President Mario Draghi's most important duties is watching his mouth. One ill-considered utterance is enough to sow panic on the financial markets.

But during a press conference earlier this month, Draghi allowed himself a telling slip.
Speaking to gathered journalists at the Spring Meetings of the International Monetary Fund and the World Bank, Draghi twice almost uttered a word he has been at pains to avoid. "Defla…", Draghi began, before stopping himself and continuing with the term "low inflation."

Yet despite Draghi's efforts, the specter of deflation was omnipresent in Washington during the meetings. And it is one that is making central bank heads and government officials nervous across the globe. The IMF in particular is alarmed, with Fund economists warning that there is currently up to a 20 percent risk of a euro zone-wide deflation. IMF head Christine Lagarde has called on European central bankers to "further loosen monetary policy" to address the danger.

The reason for concern is clear: Ever since the Great Depression at the beginning of the 1930s, deflation has been seen as one of the most dangerous illnesses that can befall an economy. Several countries at the time fell victim to a downward spiral consisting of falling prices, rapidly rising unemployment and shrinking economic output -- a morass that took years to escape. Because prices were falling, people stopped spending in the hope that everything would become even cheaper. Companies were unable to sell their products and many went broke, which led to millions of people losing their jobs and a further squeeze on consumption.

Japan provides a more recent example, where the economy has been largely stagnant for years amid falling prices. Is the euro zone now facing a similar nightmare?

The inflation rate in the common currency zone sank to 0.5 percent in March, dangerously close to zero and far away from the ECB's target of 2 percent.

Graphic: Falling inflation in the euro zone.
To enlarge graph click here

'No Evidence'

Still, both Draghi and Jens Weidmann, head of Germany's central bank, the Bundesbank, continue to insist that there is no reason to worry at present. At the IMF Spring Meetings, Draghi said "we see no statistical or model-based evidence of a self-feeding, broad based falling of prices. ... In other words, we have no evidence that people are postponing spending waiting for lower prices."

Despite the reassurances, the ECB is doing all it can to prepare for the worst, as Draghi himself has made clear. The ECB Governing Council is unanimous in its commitment to using "unconventional instruments" in order to "cope effectively with risks of a too prolonged period of low inflation," Draghi said at a recent press conference at the bank's Frankfurt headquarters. A measure is even being considered that has long been seen as taboo: quantitative easing. QE, as it is known, involves central banks buying up significant amounts of securities as a way of pumping money into the markets and thus stimulating both the economy and inflation.

Other central banks, particularly the US Federal Reserve, have used the method in recent years to combat the effects of the financial crisis. But in the euro zone, many monetary policy purists, such as Bundesbank head Weidmann, are wary of the solution. The concern is that such a flood of liquidity could encourage governments and companies to delay necessary structural reforms.

After all, the ECB has indicated that securities purchases under a QE program could be unlimited. Should an initial program -- of, say, a trillion euros -- prove ineffective, then further efforts would follow.

The ECB has also already begun identifying which sovereign bonds and in what quantity they might seek to purchase. Two alternatives have been considered. The first envisions making purchases in line with the euro-zone member states' share of ECB capital. That would mean that German sovereign bonds would make up roughly a quarter of the purchases, 20 percent French, 18 percent Italian and so on.

A Broader Debate

The second scenario would be that of adhering to market share. That would result in 22 percent each for French and German bonds and 25 percent for Italian, for example. In order to have a more direct effect on the business sector, the ECB is also considering the purchase of company securities.

Should plans for such large-scale purchases ever become concrete, a broader conflict within the ECB Governing Council is almost a certainty. Conservative policymakers, for example, are only supportive of sovereign bond purchases if they come from countries with top ratings. But that would mean that ECB money would go to countries where it isn't needed -- like Germany or Holland. Germany's Bundesbank, for its part, is opposed to any plan that would result in risk-sharing among euro-zone member states

Weidmann's Dutch counterpart, Klaas Knot, likewise expressed skepticism during a meeting in Amsterdam.

Many concerns center around the high price tag of such a shopping spree. The Bank of England, for example, has spent some £400 billion (€486 billion, $673 billion) on sovereign bond purchases and its balance sheet is five times as large as it was before the financial crisis as a result. The effectiveness of the strategy is debatable.

Indeed, central bankers of all stripes speak quietly of quantitative easing as being more of a "weapon of last resort." Draghi, they say, is welcome to put it on display, but few want to see him actually fire it.

As such, should action become unavoidable in June when the ECB Governing Council presents the next medium-term outlook, other strategies appear more likely.

A so-called negative deposit rate could, for example, be used to penalize banks that deposit their money overnight with the ECB instead of loaning it out to companies. One possible scenario foresees coupling a punitive rate of minus 0.1 percent with a further prime rate cut to 0.15 percent.

'Big Bertha'

One central banker says that the ECB would most likely assemble an entire package of measures -- one which might also include long-term, low interest loans to banks. The ECB has taken similar steps in the past

But the massive three-year tender the ECB issued in 2012 -- a package Draghi has referred to in the past as "Big Bertha" in reference to a World War I howitzer -- was used heavily by the recipient banks to buy sovereign bonds. To prevent a repeat, central bankers are considering offering particularly attractive rates in exchange for banks increasing the amount of money they loan out. Just how compliance would be monitored remains unclear.

Finally, the ECB has considered several times in the past buying up asset backed securities from banks. These securities, widely known simply as ABS, are notorious for the role they played in the US financial meltdown.

But their poor reputation is not justified in all cases, the ECB recently noted in a joint paper with the Bank of England. Because ABS are an important instrument for distributing risks in a financial system, the market for the securities must be urgently resuscitated, the paper argued.

Were the ECB to emerge as a buyer, it could prove beneficial in several different ways. For one, it would inject liquidity into the market; for another, it would act as a catalyst for banks to increase corporate lending. Both effects would counter the threat of deflation.

But should falling prices always be cause for concern? A foray into economic history is telling. In fact, extended phases of economic growth have often been coupled with long-term price erosion. Sinking prices in Germany and the US characterized a third of the period between 1801 and 1879; in Great Britain, deflation was seen during half of that period.

Widespread Suffering?

And yet there still weren't mass layoffs or widespread suffering. On the contrary: It was a period of rapid industrialization. Sinking prices came alongside increasing prosperity and growing employment.

Technical advancements and mass production meant an explosion of products of all kinds and the flood of supply pushed prices downward. But demand also increased as a much broader segment of society was able to afford products that had previously been perceived as luxury items -- such as cotton fabric.

The prevailing currency system at the time also played a role, at least temporarily, in creating pressure on prices. And it did so automatically. Up until World War I, money in most countries was backed by gold, meaning that each currency unit represented a certain amount of the precious metal. The amount of gold a country had in its reserves determined how much money could be in circulation.

If the inhabitants of a country purchased too many products from abroad because they were cheaper there, the country would in turn pay down its import surplus by transferring part of its gold reserves to the exporting nation. 
The result was that the amount of money circulating in the exporting country increased as would prices. The opposite phenomenon was seen in the importing country; shrinking gold reserves resulted in declining prices. It also meant that the products of that country became more competitive and both domestic and foreign demand increased, as did prices. Equilibrium returned between price levels and economic output.

Two Sides of the Same Coin

Under this system, inflation and deflation served as mechanisms that redressed imbalances between the economies of individual countries and injected equilibrium into the global economy. There wasn't anything particularly frightening about inflation or deflation during the era; people merely viewed it as two sides of the same coin.

Sentiment has shifted in the period since. Since at least the 1930s, the word deflation has become a conversation stopper says Jörg Krämer, chief economist at Commerzbank, Germany's second-largest bank. "As soon as someone warns about it, people become frozen with fear," he explains.

But how can it be that the very same phenomenon can have a favorable impact one time, but a devastating one the next?

As so often proves to be the case, it depends on the circumstances. If, for example, technological advances and higher productivity combine to reduce prices, then there is a corresponding increase in prosperity. When products get cheaper, demand is stimulated because more people are able to afford them. Often, a company's revenue rises rather than falls because the increase in the number of products sold more than offsets the drop in price. It's a development still in evidence today with products like computers, smart phones and flat-screen televisions.

Deflation only becomes really dangerous if there is an excessive drop in prices. "If that happens, then companies cannot keep up via labor cost reductions, leading profits to melt away," says Krämer. That's what happened in the United States during the 1930s after the stock market crash caused prices to fall by a total of 25 percent. "US companies, on average, didn't have any profits during 1932 and 1933," says Krämer. "Companies curbed their investments and the economy collapsed."

Banishing the Specter

Sinking prices can also become unbearable in situations in which companies and consumers are strapped with debt. If prices fall, money becomes more and more valuable and leads to greater debt pressures because the face value of the debt doesn't change. Under those circumstances, many companies are no longer capable of servicing their debts and are forced into bankruptcy. This phenomenon most recently reared its head during the global financial crisis, and it continues to threaten crisis-plagued Southern European countries, with their high debt levels.

Despite this, the low and in some cases already negative inflation rates -- particularly in Ireland, Portugal and Spain -- are simply the manifestation of painful, but deliberate adjustment processes. During the boom years from 2000 to 2008, unit labor costs rose by up to 40 percent in the so-called PIGS countries. Now they are falling again, increasing the international competitiveness of these economies.

Finally, as ECB chief Draghi never tires of pointing out, 70 percent of the inflation rate decline within the euro-zone is attributable to surprisingly low energy and food prices. These figures are "very helpful for the economy," says Krämer.

Bundesbank head Weidmann has a similar opinion. Like many other central bankers, he believes the economy will continue improving, also in the euro-zone crisis countries, such that prices will likely soon rise again. His best-case scenario would be if the March inflation-rate drop turned out to be an exception with no bearing on developments in the near future. This would allow the ECB to sound the all-clear in June. And banish the specter of deflation.

Translated from the German by Charles Hawley and Daryl Lindsey

April 22, 2014 6:24 pm

A more equal society will not hinder growth

Inequality damages the economy and efforts to remedy it are, on the whole, not harmful

Ingram Pinn illustration©Ingram Pinn

Inequality is a hot topic right now. The reaction to Thomas Piketty’s Capital in the Twenty-First Century shows the rising tide of anxiety. But Mr Piketty devoted almost no attention to why inequality matters or whether the cost of reducing it might outweigh any likely benefits. This lacuna needs to be filled.

Much discussion of the book has focused on the political aspects of inequality. But the economic aspects also merit attention. To my surprise, the staff of the International Monetary Fund, the most staid of institutions, addressed these questions in February in a note entitled Redistribution, Inequality and Growth. It came to clear conclusions: societies that start off more unequal tend to redistribute more; lower net inequality (post- interventions) drives faster and more durable growth; and redistribution is generally benign in its impact on growth, with negative effects only when taken to extremes.

The conclusions are noteworthy. So why might they be true?

The obvious explanation for the first conclusion would be that, at least in universal suffrage democracies, the bigger the market-generated inequality, the greater the political pressure for redistribution, since votes are distributed more equally than money. Those with money might respond by seeking to disenfranchise the poor, either directly or indirectly. They might also seek to attract support from those lower down the income scale by emphasising social and cultural concerns. Moreover, the wealthy always exercise political influence. That redistribution usually wins out is not astonishing, but is noteworthy.

Now consider the second conclusion. Inequality might in fact promote growth because it reflects high incentives for innovation and entrepreneurship. It might also mean higher savings and so higher investment, since richer people may well save a higher fraction of their income than poorer ones. Indeed, John Maynard Keynes himself once used this as an argument for Victorian inequality. In poor countries, inequality might also give a part of the population the resources with which to start a business or get an education. Yet, on the other side of the argument, inequality might deprive the poor of the ability to stay healthy, acquire skills or look after and educate their children. It might generate instability, as politics polarises between low-tax conservatism and redistributive populism. It might also thwart the forging of consensus on how to respond to adverse shocks.

On the third conclusion, it is easy to see why redistributive policies might hurt growth. The economic costs of taxes rise disproportionately, as they reach very high levels. At the same time, some redistributive policies might impose very modest or even negative costs: the elimination of arbitrary tax loopholes favouring the rich is an example; the use of tax revenues to finance public investment, better education or universal health services is another. Such measures might promote greater equality and higher growth.

In theory, then, the connections between inequality, redistribution and growth could go in different directions. The answers need to be found in careful analysis of the evidence, however imperfect the latter is sure to be. The results of the IMF’s study are strikingly clear.

Over the past half century, notes the IMF study, market (that is, pre-intervention) inequality has been rising in high-income countries and falling in developing countries. This is in line with what one would expect in an era of globalisation. Moreover, as one would also expect, the difference between market and post-intervention inequality in high-income economies is smaller than elsewhere, because they have far more redistributive states.

The analysis relies on cross-country data on growth, inequality and redistribution. It looks at the impact of both inequality and redistribution on growth in real incomes per head over five years and at the duration of the growth spells. On the five-year growth periods, the clear finding is that inequality reduces growth. The direct impact of redistribution is negligibly negative. But the indirect effect, via reduced inequality, is beneficial to growth. Again, higher inequality reduces the likelihood that a spell of growth will last. Finally, the study finds that increasing already very high levels of redistribution will harm growth. Yet, below the policy extreme, further redistribution does not harm growth.

The implication of this work is perhaps surprising. Not only does inequality damage growth, but efforts to remedy it are, on the whole, not harmful. These are just statistical relationships derived from data that cover a large number of heterogeneous countries. Nonetheless, the findings suggest that trade-offs between redistribution and growth need not be a big worry.

These findings are also consistent with casual observation. Europeans are aware that the economies of the highly redistributive Scandinavian countries have outperformed the less redistributive countries in the south

Moreover, these high-tax countries are also not suffering fiscal crises. Again, anybody who understands a little about development knows that the far more equal east Asian countriesnotably, Japan and South Koreavastly outperformed the far less equal countries of Latin America after the second world war. The Asians invested far more successfully in education and, in this and other ways, brought the population inside their dynamic modern economies.

This analysis cannot, of course, end the political debate on these huge topics. Instead, it opens it up, in a rather optimistic direction.

It is not only possible, but valuable, to marry open and dynamic market economies to the sense of shared purpose and achievement brought by tolerable degrees of inequality. Moreover, less inequality is likely to make economies work better by increasing the ability of the entire population to participate, on more equal terms. An important condition for this, in turn, is that politics not be unduly beholden to wealth.

Managing such a combination of market dynamism with effective redistribution is one of the defining political challenges of our era. It will take purposive action by states and greater co-operation among them, notably on taxation. Yet if even the staff of the IMF is analysing this once largely taboo topic, its hour has surely come.

Copyright The Financial Times Limited 2014.