Whatever the answer, ECB needs to do more


“Central banks don’t have divine wisdom. They try to do the best analysis they can and must be prepared to stand or fall by the quality of that analysis.”

Mary Kay Ash, American businesswoman

“In central banking as in diplomacy, style, conservative tailoring, and an easy association with the affluent count greatly while results far much less”

John Kenneth Galbraith

The Euro Zone’s inflation rate has been heading relentlessly lower. In November 2011, it was 3.0% year on year. Provision data for November 2013 showed it had fallen to 0.9%. Yes, that was up a little on October’s level, but producer prices data and the absence of strong growth anywhere in the region suggest the balance of risk is that inflation falls further.

The problem is actually extending across most of Europe, even outside the strictly speaking Euro Area. Since April, prices (adjusted for taxes) have fallen in Greece, Italy, Netherlands, Portugal, Slovenia and Slovakia, as well as in the non-EMU group of Bulgaria, the Czech Republic, Latvia, Lithuania, Hungary and Romania. Prices have been falling in Spain since May, in France since June and even in Germany over the past three months.

Deflation is generally seen as a negative phenomenon. When inflation is close to zero, companies, households and even governments have a harder time cutting their debt loads. Profits are squeezed—threatening investment and jobs—and consumers may hold off on big-ticket purchases.

Modern central banks strive to keep inflation low, but significantly above zero; several have set 2% as their medium-term goal. Very high rates of inflation, like the double-digit rates of the late 1970s, distort markets, hurt lenders and can undermine economic and political stability. Falling prices, or deflation, can also distort markets, prompt consumers and business to defer purchases until prices fall and can hurt borrowers; it also makes it nearly impossible for a central bank to cut inflation-adjusted interest rates below zero, as they often do in recession. Keeping inflation comfortably above zero protects an economy from sliding into deflation and makes it easier for a central bank to stimulate the economy. It also makes it easier for employers to reduce inflation-adjusted wages; workers often are happier with a 1% raise when inflation is at 2% than with a 1% wage cut when inflation is at zero, even though they are—to economists—exactly the same.

These days when a deflation scenario is discussed Japan is very often used as a template. That is easily understandable, having seen recent economic history. In the European case there is even one more fundamental reason to believe deflation is a possibility for the Euro Zone: demographics. Ageing populations create a propensity to deflation. Old people borrow less and consume less. And nowhere outside of Japan are there bigger proportions of old people than in Europe. The average Italian or German isn’t much younger than the average Japanese.

Good and bad deflation

The overall price level in the economy may fall for two reasons. First, productivity increases may cause prices to fall. As will falling input prices - for example lower oil prices. Second, a general contraction in aggregate demand - for example due to tighter monetary policy - can reduce the price level. Economists normally call productivity increases and falling oil prices a positive supply shock. They are unilaterally positive as a positive supply shock overall increases prosperity. That’s the good deflation. Conversely a general decline in prices, which is a result of weak aggregate demand - a negative demand shock - is purely negative as it usually leads to higher unemployment and lower capacity utilization in the economy. That’s the bad deflation.

In general the economic development in Europe in the last five years has been characterized by very weak demand development. It has created clear deflationary trends in several European economies. That certainly has not been good. It has been a bad deflation. However, the recent decline we have seen in European inflation is primarily a result of falling oil prices - that is a good deflation, which shouldn’t be worrying. The paradox is that these recent (positive) deflationary trends in the European economy seem to have caused the European Central Bank to wake up and reduce interest rates. and it is now being speculated that the ECB will undertake further action to ease monetary policy.

According to the monetary policy textbook central banks should not respond to ‘good deflation’. This obviously could give reason to question the fact that the ECB is now finally moving to ease monetary policy. But the truth is that the ECB in the past five years have failed to sufficiently aggressively ease monetary policy to avoid bad deflation.

Obviously they have been short in easing action not for inattentiveness and, I assume, not for lack of understanding of the basic principles of the modern central bank textbook. There are in fact many ways to slice the good versus bad deflation debate. A recent paper from Goldman Sachs (Global Markets Daily: ‘Good’ or ‘Bad’ Deflation in the Euro area – November 22nd) has been quite helpful in explaining the dilemma policy makers are facing in a monetary union of nations with diverse economic structures and cycles.

The argument for the ‘good’ camp is that falling periphery price levels are a necessary evil, needed to restore competitiveness and growth. The argument for the ‘bad’ camp is that deflation in the periphery may exacerbate some of the underlying fiscal problems and is not actually needed to restore competitiveness, which would ask merely for lower inflation relative to Germany. This line of thinking argues that Germany and the smaller current account surplus countries need to accept higher inflation, so that periphery countries can regain competitiveness without falling price levels.

The difference between the two camps lies in who the periphery is supposed to regain competitiveness against. The ‘good’ deflation camp wants to preserve competitiveness in northern Europe via low overall inflation, forcing periphery countries into deflation. This line of thinking aims to restore periphery competitiveness relative to the rest of the world (and of course relative to Germany), while preserving the competitiveness of the overall Euro area (read northern Europe) relative to the rest of the world. Ireland’s 5% drop in core prices can be seen as a template for this line of thinking.

The ‘bad’ deflation camp thinks the periphery should regain competitiveness principally vis-à-vis Germany, with higher German inflation eroding some of its own competitiveness gains versus the periphery over the last decade. This view could also entail a competitiveness loss in the Euro area versus the rest of the world, as higher overall inflation could erode the competitiveness of northern Europe (under the assumption of a stable nominal exchange rate). This is where the debate over ‘good’ and ‘bad’ deflation links up with the discussion over the Euro area current account surplus. The ‘bad’ deflation camp wants that current account surplus to fall as Germany imports more from the periphery and loses competitiveness vis-à-vis the rest of the world. The ‘good’ deflation camp argues that the German current account surplus hardly comes at the expense of the periphery or intra-European adjustment and therefore wants to preserve it.

Like in most economic debates, there is merit to both sides. Of course, strong German competitiveness and the German current account surplus hardly prevent the periphery from pursuing needed structural reforms. Indeed, as Spain’s Economy Minister pointed out at the end of December, strong German growth indirectly benefits manufacturing in the periphery via Europe’s manufacturing chain. And it is hard to dispute that structural reform in the periphery needs to be pursued more aggressively. Indeed, periphery gains in price competitiveness have often lagged impressive gains in wage competitiveness because product markets in the periphery still suffer from barriers to entry.

At the same time, there are good reasons to support the case of the ‘bad’ deflation camp. First, although periphery interest rates have fallen since the famous “whatever it takes” sentence from Draghi in July 2012, there is little doubt that nominal and real interest rates in the periphery remain very high. Periphery deflation would raise real interest rates, unwinding some of the recent progress in easing financial conditions. Second, Japan’s experience in recent years shows that currency markets tend to reward high real interest rates with a stronger exchange rate. Deflation in the Euro area and rising real rates could result in higher EUR/USD, tightening financial conditions on a broader basis even further (and beyond the periphery). Third, the kind of internal devaluation seen in Ireland may simply not be politically feasible in the rest of the periphery. There is little doubt that resistance to further nominal wage cuts and product market reforms on the periphery is growing. Eroding real wages via rising price levels is the easier way out. Fourth, deflation on the periphery risks destabilizing fiscal accounts, since declining prices can boost debt levels relative to GDP.

The denominator effect

This last point (deflation on the periphery risks destabilizing fiscal accounts) is the most worrisome at the moment. If Club Med states have to deflate, their debt trajectories risk spinning out control. The two policy objectives of EMU crisis strategy are in contradiction, as also the OECD recently spelled out last month: intra-euro price level adjustments to restore competitiveness make fiscal targets much more difficult to achieve. Falling nominal GDP means the debt burden is rising on a shrinking base. The ‘denominator effect’ is deadly when the public/private debt stock is high: 276pc in Italy, 300pc in Greece, 330pc in Spain and 389pc in Portugal. It is why Italy’s public debt has jumped from 119pc to 133pc GDP in just over two years despite draconian austerity and a primary budget surplus. And when average euro-area inflation undershoots the two percent target, the conflict between intra-euro relative price adjustment and debt sustainability is more severe. That is why, in my opinion, intra-euro price adjustments have to be more symmetric and in the debate previously exposed from Goldman I am leaning more into the ‘this deflation is bad’ camp. A recent paper from Bruegel (a famous Bruxelles-based think-tank) explains this view pretty well. “… a more symmetric intra-euro area price adjustment should facilitate intra-euro area competitiveness adjustment. If inflation has to be 1 percentage point lower in Italy and Spain because the overall euro-area inflation rate undershoots the two percent target, the persistent primary surplus has to be higher in Italy by 1.3 percent of GDP and in Spain by 1.0 percent of GDP, according to our calculations. Consistent with the ECB mandate, average inflation in the euro area should not be allowed to fall below the two percent target, and Germany and other euro-area countries with a strong competitive position should refrain from domestic policies that would prevent domestic inflation from rising above two percent. Therefore, the ECB should do whatever it takes, within its mandate, to ensure that inflation does not fall below the 2 percent target.”

Unfortunately we are still far from this even if some activism from Mario Draghi, especially compared with the previous Trichet management, is undeniable. In October, according to the European Central Bank, M3 money growth fell to 1.4pc from a year earlier (see Chart 1), lower than expected and far below the bank’s own 4.5pc target deemed necessary to keep the economy on an even keel. Monetarists watch the M3 data -- covering cash and a broad range of bank accounts -- as an early warning signal for the economy a year or so in advance.


It is not true that the ECB is a replica of the old Bundesbank. The Bundesbank would never have let M3 growth fall so low for so long in Germany during the D-Mark era.

Mario Draghi vs Richard Koo. An artificial Q&A.

So. How close are we to getting Japanised ?

In his latest Q&A after the monthly ECB meeting on Dec 5th, Draghi delved into the topic extensively. In the opening remarks he basically said that, since “inflation expectations for the euro area over the medium to long term continue to be firmly anchored in line with our aim of maintaining inflation rates below, but close to, 2%.... we may experience a prolonged period of low inflation, to be followed by a gradual upward movement towards inflation rates below, but close to, 2% later on”. In the following Q&A a question of this tenor was inevitable: ”… in Japan those (inflation) expectations moved a little bit late. They didn’t really tell us anything until it was too late for the central bank to do anything. Given that, how appropriate is it that you are placing so much faith in these inflation expectations in warranting not doing more now?

Draghi’s answer has been quite elaborate, stating 5 reasons why situation in Europe is different from Japan two decades ago. In the last few years I have been a constant reader of Richard Koo, Chief Economist of the Nomura Research Institute. He has been, in my opinion, the best in explaining a lot of mechanisms behind the ‘balance sheet recession’, the special beast of recession we have been suffering after the 2008-2009 crisis in most of the western world (and some countries, like obviously Japan, much earlier than that). So I think it is worth listening also to his subsequent comments to Draghi ‘we beg to differ’ explanations.

Draghi: “The first (reason)… we have taken decisive monetary policy measures of great significance at a very early stage, even when, as a matter of fact, inflation was not at the levels at which it is today. It was way higher and way closer to 2% and this did not happen in Japan.”

Koo:”…the US and Europe were facing massive bank crises from the start, while Japan in the early 1990s had only a loan scandal at two small credit unions and the failures of ‘jusen’ housing loan companies to deal with. Hence there was no need to drop interest rates and supply liquidity to save the banking system. It was only in the autumn of 1997, fully six years after the bubble collapsed, that Japan experienced a systemic banking crisis. And long before that the BOJ had slashed short term rates from 8% during the bubble era to nearly zero.”

Draghi: “The second reason why – by the way, this is an interesting comparison which you can imagine we look at with great attention – but there is a second reason why this comparison is not actually there. We are in the process of doing the asset quality review. You are aware that the situation in Japan lasted much longer than it should have because the balance sheets of the banking system and the private sector were burdened, and had to be deleveraged and the action to induce this deleveraging lacked for many years. The review is expected to, produce this action. And as a matter of fact, this action has already started, and is actually underway right now. Much of it, well, some of it, is actually taking place even before the review is being implemented.“

Koo: “In fact, however, it was because Japan’s private sector was already deleveraging at a very rapid pace on its own initiative that the economy weakened so quickly. I suspect the ECB president was also implying that Japanese banks were slow to write off their bad loans. But it only appeared that way from the outside because the Japanese tax code made it difficult for banks to remove bad loans from their balance sheets. In fact, a look at trends in loan-loss provisions over time makes it clear that Japanese banks were rapidly writing off their bad assets from the very beginning.”

Draghi: “The third reason is that the situation of the private sector balance sheets is not at all comparable in the euro area. It is not at all comparable with what it was in Japan at that time.”

Koo: “However, it is difficult to tell what he meant to say as he did not explain which of the two he thought was in better shape.”

Draghi: “The fourth reason is that the countries in the euro area have made significant progress in addressing their structural weaknesses. Now, in some countries the progress toward structural reforms has been slower, in other countries faster, but you see that the situation today is completely different from what it was two years ago.”

Koo: “But when an economy is in a recession triggered by balance sheet problems, no amount of structural reform will improve the situation—and it may actually make things worse. This should be clear from the Koizumi and Hashimoto reforms in Japan and Germany’s experience from 1999 to 2005. The average unemployment rate across the EuroZone is at an all-time high of 12.1% and is higher than 20% in some nations. Frankly, I find it difficult to understand how the central bank governor could claim that the EuroZone would never end up like Japan— where, incidentally, the unemployment rate has never exceeded 5.5%—because Europe was pursuing the right policies.”

Draghi: “There is a fifth reason. As a matter of fact, if you look at the inflation expectations in the euro area and the corresponding inflation rates you would see that in Japan the inflation expectations were disanchored quite significantly, and for a long period of time, which is not something we are seeing here.”


Koo: “While a simple comparison of the yields on Japan’s index-linked government bonds— which are characterized by extremely low liquidity—and those on fixed-coupon JGBs may suggest that is the case, questionnaire surveys conducted by the Cabinet Office and the BOJ make it clear that over the past 20 years the general public not only did not feel that prices were falling but actually perceived an increase in prices. The main reason for this is that the price of utilities and other essential public services continued to rise during this period. But the fact that people perceived conditions as being inflationary rather than deflationary means they did not put off purchases because of an expectation that prices would fall further.”

As can be inferred from this artificial Q&A, making comparisons is difficult, but just dismissing that Japan story can teach us something is likely the wrong attitude. Yes, the famous saying “history does not repeat itself but rhymes” can be an oversimplification in this case. Mr. Koo’s conclusion is a bit harsh in my view but I tend to agree with the general concept: “In short, From Japan, both the European capitals and the east coast of the United States are a 12-hour flight away. But Europe seems to view Japan as being a far-off land (the “Far East”!). Mr. Draghi is clearly one of the brightest individuals in policy circles today, and the depth and quickness of his intellect are obvious to anyone who has seen his news conferences. However, in my view, the concept of ‘garbage in, garbage out’ applies as much to eminent economists as it does to anyone else. The wide gulf between economic thought in Europe and Japan is plain to see when we compare the US, which recognized its similarities with Japan’s experiences soon after the crisis hit and found a path to recovery, and Europe, where the policymaking authorities continue to emphasize their differences with Japan while unemployment is climbing to new highs five years after the crisis struck.”

The Bank of Japan’s paralysis in the 90s and early 2000s seems extraordinary to us now in the era of Abe-Kuroda determination, and so do the arguments made by the governors of the day, Masaru Hayami and Toshihiko Fukui. Mr.Hayami almost seemed to welcome deflation, thinking that it would force the political class to ram through root-and-branch reform, although it did no such thing. “I am not worried about the fall in prices,” he said famously in January 2001. Mr.Fukui even said rising unemployment was a “good thing”. It would hold political feet to the fire.

The details are recounted in the brilliant “Princes of the Yen” by professor Richard Werner, now at Southampton University according to which the most recent upheaval in the Japanese economy is the result of the policies of a central bank less concerned with stimulating the economy than with its own turf battles and its ideological agenda to change Japan’s economic structure.

I think it is impossible to say that ECB’s attitude has a long-term plan behind where monetary stimulus is being withheld because it might help slackers off the hook with the definition of slacking determined by a tiny cell in the German finance ministry. Anyway in political and economical circles the argument of ECB feeling compelled to avoid being too easy is made regularly: that should obviously be done in order to keep a bit of pressure on governments implementing badly needed structural reforms. But we need to be careful since, in the end, differences between Japan and Europe may turn out to be at our disadvantage instead of being reassuring ones. Japan’s economy might not have done much during the past two decades, but on a per capita basis Japanese have largely kept pace with other citizens of developed markets. With a caveat: That per capita growth has largely come thanks to very large and persistent government deficits. By contrast, the euro zone is trying to do growth without the deficits, which is one key reason why the analogy between the euro and the yen can go only so far. Japan might well have had benign deflation. The euro zone’s is unlikely to prove the same.

Alessandro Balsotti