EUROZONE MUST ACT BEFORE DEFLATION GRIPS / THE FINANCIAL TIMES COMMENT & ANALYSIS

January 11, 2015 4:56 pm

 

Eurozone must act before deflation grips

 

Wolfgang Münchau

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A helicopter drop would work — but I fear it would be too unconventional for the European mind

 

©AFP

 

 

Deflation in the eurozone has nothing to do with the price of oil. Its cause is a series of policy errors over several years — the interest rate increase in 2011, the failure to act when inflation rates dropped off a cliff in 2013 and the pursuit of austerity in a recession.

 

If the European Central Bank had met its inflation target of “close to but below 2 per cent”, the oil price collapse would have been harmless. Inflation would have fallen from 2 per cent to 1 per cent at most. Central bankers would have been right to ignore it. But if you start at close to zero, you get deflation.

 

A year ago it was said that the eurozone was only one shock away from deflation. Since then, we have had two: Russia’s aggression against Ukraine and the fall in the oil price. Shocks happen. The fall in crude oil prices would normally be benign for a net oil importer such as the eurozone.

 

But beware the second-round effects, those that come with a delay. There are already signs that German pay negotiators are dropping the ECB’s 2 per cent inflation target in their wage formulas.

They tend to calculate increases by adding together the ECB’s inflation target of 2 per cent and some portion of the increase in German productivity. But with inflation stuck at zero that formula leaves only productivity, which has also not grown by much. If inflation expectations fall, so will wage increases.

Allison Mandra at Bruegel, a Brussels-based think-tank, calculated that nominal wages in Germany went up 2.4 per cent in 2014. This, unfortunately, is as good as it will get. The early signals from the 2015 pay round suggest that wage increases are heading lower again.

German companies are behaving perfectly rationally. Inflation in the eurozone recently turned negative. The yields on German bonds — negative rates for two-year paper; zero for five-year — tell you that investors expect inflation to be close to zero for a long time. Why should company wage negotiators expect anything different?

Low inflation leads to wage moderation, which in turn bears down on future inflation. By the time the oil price effect falls out of the inflation index — in about 12 months — the 2015 wage round kicks in dragging down inflation further.

What does this scenario imply for policy? The ECB is now very likely to vote in favour of a programme of quantitative easing — the purchase of sovereign debt — when it meets on January 22.

My expectation is that QE will fall short for a number of reasons.

The size of the purchases may not be large enough. It may simply not work as well in an economy with a smaller capital market and a different system of housing finance compared to the US or the UK, where QE was effective because it stabilised housing. The absolute worst variant of QE, currently under discussion, is one where each national central bank buys the debt of their own governments, which would effectively be the end of a single monetary policy. If that happens, you will wish that you never asked for QE in the first place.

What else is left? The most extreme monetary policy tool available would be a classic helicopter money drop, as advocated by the economists John Muellbauer and Willem Buiter. Professor Muellbauer proposes a modest €500 payment from the ECB to each citizen or resident, but there is no reason not to go higher if you really wanted to create inflation. A payment of €10,000 per citizen would translate into €3tn, which would be of a size equivalent to the QE programme in Britain. A helicopter drop would work but sadly, I fear, it would be too unconventional for the continental European mind.

 

A slightly more realistic possibility would be a combination of QE, an external stimulus from oil and a fiscal boost. The eurozone’s fiscal rules leave little room for an increase in ordinary spending, or a reduction in taxes. But the fiscal rules are sufficiently flexible to allow countries to deal with emergencies. After last week’s terror attacks in Paris, it would be both feasible and appropriate for President François Hollande of France and other European leaders to invoke exceptional circumstances for a fiscal boost related to spending on internal security — without offsetting savings or tax increases. If terrorism does not qualify, what else?

 

The eurozone’s best hope for now remains: an ambitious QE programme, a positive oil price effect on consumption and investment, and a rise in fiscal spending. This might just work.

Based on previous experiences with eurozone policy co-ordination and a lack of urgency among policy makers, the odds of success are not great. My baseline scenario continues to be one of secular stagnation. We have repeated each mistake Japan made in the 1990s — and then added some of our own. It is a tragedy that economic history has no traction on European policy makers. This is the real reason deflation is back.