Why Europe needs deflation
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Mario Draghi, the president of the European Central Bank (ECB), recently noted that the strength of the euro could warrant “further stimulus measures”. Despite various jawboning tactics employed by ECB officials, since mid-2012 the currency has shown significant strength leading to worries of weak external demand. Many now expect the ECB to lend at negative interest rates and—more importantly—engage in quantitative easing to fight the threat of deflation.
The roots of the problem facing Europe today extend to the early 2000s, when just years into a new monetary union the ECB jumped up credit creation leading to a massive property bubble—mainly in peripheral countries like Spain, Portugal and Ireland. Notably, the growth rate of Europe’s M3 money supply increased three-fold between 2004 and 2007. The ECB eventually tightened the supply of credit—M3 growth dropped drastically starting 2008—putting an end to the property bubble.
Meanwhile, the availability of massive liquidity also led banks to lend to profligate peripheral governments. The yield on government bonds of PIIGS (Portugal, Italy, Ireland, Greece, and Spain), despite their lower credit standing, converged with that of relatively stronger borrowers like Germany trusting the ECB would offer a bailout in case of a default. Increase in public spending to prop up demand following the downturn further added to the debt load, and the sovereign debt crisis of 2010 eventually exposed the poor state of European public finance most notably in Greece.
The impact of loan defaults in the aftermath of the burst of the housing bubble, combined with the sovereign debt crisis led to deterioration in the health of European banks. And troubled banks refused to lend preferring instead to accumulate capital to cushion the impact of bad assets.
Ignoring the real causes behind the slump, policymakers saw lack of demand as the primary cause behind low growth. Naturally, then, more spending should be the solution, and Draghi’s recent enthusiasm for devaluing the euro is thus anticipated with optimism. To cheapen the euro, many speculate the ECB will engage—like the Federal Reserve and the Bank of Japan—in bond purchases that would increase liquidity in the system. Bond purchases from banks, it is hoped, will in turn help revive domestic demand through increased bank lending. There is reason to be skeptical of both beliefs.
The last time the euro fell 12.8% against the dollar, between April and December 2011, industrial production contracted sharply. An even steeper fall of 16% between November 2009 and early May 2010 failed to revive growth. Draghi would clearly hope this time turns out to be different. Capital infusions too have been tried before, but with little success in increasing loans to the private sector. Long term refinancing operations (LTROs) infused capital worth a trillion euros into European banks in 2011 and 2012. However, according to Fitch ratings, in 2011 and 2012 top European banks cut back their exposure to corporate borrowers by 9%.
The aversion has continued to the present, with loans to the private sector for the period December 2013 to January 2014 contracting by 2% year over year. Note that the decrease in exposure to corporate borrowers was accompanied by an increase in exposure to government bonds—which increased by over 25%—driving down the borrowing rates of peripheral countries. Notably, in early March this year, the yield on Spanish 5 year bonds converged with that of US bonds. In essence, the ECB’s attempts to revive domestic demand have simply helped finance the spending of governments.
Irrespective of whether a weaker euro revives export demand, or European banks restart private lending, these would still not address the real problems facing Europe. Post-2008, not very different from other economies, Europe tackled the excesses of a mal-investment boom fuelled by cheap credit with more of the same. The good times were the product of ECB’s credit expansion policy that distorted relative prices and allocated resources—albeit in error—toward sectors like the construction industry. The tightening of credit around 2008 led to the reallocation of resources according to actual market forces—that is, away from the construction industry—bringing an end to the boom.
Instead of allowing mal-investments to liquidate, the ECB took measures to prop them up. This involved a policy of near zero interest rates combined with stimulus packages worth trillions to recapitalize weak banks and lend to effectively bankrupt governments. While the distortionary effects of direct monetary stimulus measures are still unclear, except for signs of another property bubble in the making, to the extent banks have abstained from lending such distortions might have been partially prevented. The case with lending to governments, however, is unambiguous. Ignoring all the fuss over austerity, the actual spending of European governments has continued to increase compared from pre-crisis levels.
Interestingly, despite massive stimulus measures, news in recent times has concentrated on the need for more action from the ECB to stimulate demand. This has mainly emanated from the fear of deflation. Europe has witnessed “low-flation” for years now, and the downtrend in the rate of inflation is clearly worrying policymakers. This, however, is not a monster it is made out to be.
Firstly, falling prices do not mean the end of growth. In the 19th century, the United States witnessed two periods of deflation, of about 50% each, extending over decades all while the economy experienced steady growth. In fact, in most of history, deflationary episodes have not correlated with low growth.
In the paper Deflation and Depression: Is There an Empirical Link?, Federal Reserve economists Andrew Atkeson and Patrick Kehoe find that “nearly 90% of the episodes with deflation did not have depression. In a broad historical context, beyond the Great Depression, the notion that deflation and depression are linked virtually disappears”. The fuss about deflation has little to do with growth, but the threat that falling prices would increase the real value of public debt.
Secondly, in the absence of compensating credit expansion after a bust, falling prices are expected as banks begin to consolidate their balance sheets. Measures to counter this by infusing credit must be resisted as this will merely distort relative prices, and further misallocate resources—the very causes of the current mess. What should be enforced are structural reforms that improve price flexibility and allow unhindered resource mobility. Note that, at the moment, it is mainly the peripheral countries of Europe that experience outright deflation; just the kind of “internal devaluation” required to achieve recovery.
The real worry for European policymakers should not be falling prices but their own compulsions to find easy solutions through the printing press, and what awaits them as banks begin to lend phony credit already infused into them. This will sow the seeds of another temporary “recovery” that the ECB can celebrate as its own doing, followed by an inevitable downturn.
Natural Order will run every Monday, with a libertarian take on the world of economics and finance.