ECB Eyes QE to Fight Deflation

Last week I again cautioned that the European economy is living under a looming deflation threat. Leading politicians and Eurocrats do everything they can to deny that this threat is real, but economic facts have an irritating tendency to surface again when you least want them to. Alas, the story of deflation is gaining steam, such as with this story  from Der Spiegel’s English section:

Speaking to gathered journalists at the Spring Meetings of the International Monetary Fund and the World Bank, [President of the European Central 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.

That is of course a bit hard to quantify, of course, but the warning from the IMF is well worth listening to. Once deflation sets in, economic behavior changes in many key areas. Consumption is slowed down because consumers can make money off saving their cash and wait for prices to be lower next year; worker compensation will grow more slowly as businesses no longer have to make sure their valued employees can keep up with inflation; productive investments become more expensive because future sales will bring in less per-unit revenue than today’s production; finally,  governments start having budget problems again as spending and income grow more slowly, thus slowing down income and sales tax revenues.

Deflation is about the last thing Europe needs right now. So what do leading economists and politicians intend to do to prevent it? Back to Der Spiegel:

IMF head Christine Lagarde has called on European central bankers to “further loosen monetary policy” to address the danger.

As of right now, M1 money supply in the euro zone is growing at almost six percent per year. By contrast, current-price GDP for the euro zone is at best growing at 1.5 percent per year. This means, plain and simple, that the growth of high-powered money is four times faster than growth in demand for that money among the general public.

How much more money would Lagarde like to see the ECB print before she thinks the deflation threat is over?

It looks like someone needs to teach her about the liquidity trap. Perhaps IMF chief economist Olivier Blanchard could give her one of his old textbooks?

Der Spiegel again:

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. … Japan provides a more recent example, where the economy has been largely stagnant for years amid falling prices.

Unlike the 1930s, and unlike Japan, Europe has yet one more explosive ingredient in its deflation mix: the welfare state. Europe has been wrestling with budget deficits for five years now, subjecting itself to repeated fiscal austerity whippings that (as I explain in my upcoming book Industrial Poverty) has made the economic crisis far worse than it otherwise would have been. If deflation sets in, tax revenues will fall yet again, while the enormous costs of the welfare state will remain  as welfare rolls remain swollen to the breaking point.

What will Europe’s political leaders do when deflation causes a loss of tax revenue?

Der Spiegel does not ask this question. They do, however, notice how ECB officials frantically try to avoid talking about deflation:

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. 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.”

It is hard to see how Draghi could reach that conclusion. National accounts data from Eurostat indicate that if the Europeans are lucky, private consumption both in the euro zone and in EU as a whole will grow at a maximum of one percent, adjusted for inflation, in 2014. This is no real change for the better from 2013.

Apparently, as Der Spiegel explains, Draghi does not even believe his own words:

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.

This is verbal vanity. The ECB has already made a pledge to buy any amount of treasury bonds from anyone eager to sell. While this pledge is technically limited to countries with “troubled” government finances, it de facto means that if the financial markets pressure a country onto the “troubled” list, the ECB will extend its bond-buying guarantee to cover that country as well. Therefore, the ECB has de facto already written a blank QE check to the bond market and a step from pledge to practice would not raise that many eyebrows.

The question, of course, is if it can help fight off deflation. QE would encourage more government spending – debt spending – which is the most inefficient way to get an economy rolling again. Every other variable on the right side of the classic national-accounts identity Y=C+I+G+NX (where of course G represents government spending) is preferable as a driving force toward a recovery.

Needless to say, Europe must escape the deflation threat, but it must happen in such a way that there is a sustainable recovery on the other side. Printing money to stimulate government spending is a recipe for perpetuating the current crisis. Instead, Europe should try reforming away its welfare state. That would open 40-50 percent of the economy to new entrepreneurs, cost savings, innovation and lots of new jobs.