The Danger of Deflation: Eyes wide shut
Until now, the Europe-based ‘Masters of Austerity’ have been able to simply shrug off the devastating economic and social consequences of their policies. Even given that they were forced to openly admit that austerity is indeed recessionary in the short run, they are still loudly clinging on to the belief that fiscal consolidation was nevertheless necessary to restore much needed market confidence and that economies will be rewarded for it with a much improved growth performance over the medium run.
A similarly complacent attitude is shown concerning fiscal austerity’s twin policy of ‘internal wage devaluation’. It is now clear for all to see that internal wage devaluation is undermining price stability, which is actually a core value for the ‘Masters of Austerity’. Indeed, with both headline as well as core inflation now down to just 0.8%, the ECB’s target of ‘inflation below but close to 2%’ is significantly being breached from below.
This, however, does not seem to bother European policy-makers much. From the view of finance ministers, the danger of too low inflation spilling over into outright deflation is swept away from the discussion table by declaring that this is actually ‘good deflation’, so an outcome that is even desirable. From the ECB, the reply is a bit more intelligent and is summarised in a text box in their latest Monthly Bulletin.
According to the ECB, which bases itself on an econometric model using money based indicators and analysis, the probability of the economy finding itself in the third quarter of 2013 in a ‘medium inflationary regime’ (corresponding with the ECB’s price stability target) is 63%. Looking ahead, the ECB estimates that the probability of remaining in this inflation regime throughout the period until end 2015, is very high and more than 90%. In contrast, the probability of moving into a low inflation regime with an average of 0.5% inflation is limited in the ECB’s estimate to less than 10%.
In addition to this technical analysis, the ECB’s other response is to simply move the goal post. Whereas the former goal was to pursue an inflation target close to 2% over the medium run, ECB officials are now systematically referring to a 2% target to be reached in the long run. This allows the ECB to focus its communications on the idea that long term inflation expectations remain firmly anchored, while ignoring the disturbing downwards slide of inflation expectations over a two year horizon.
Commission Winter Forecasts questioning the official consensus
It is this area where the European Commission’s recently published Winter Forecasts are really interesting. A careful reading of the Commission’s text box on ‘disinflationary trends in the Euro Area’ allows one to identify the fact that DG ECFIN is actually casting serious doubt on the arguments put forward by the ECB, even if implicit and careful language is being used. If we decrypt the Commission’s carefully worded text and translate it into plain language, we get the following messages:
- It is dangerous to base policy on long term inflation expectations. Or as the Commission puts it:
‘Yet, as the Japanese experience with a long lasting period of mostly mild deflation since the mid 1990’s shows, long term inflation expectations do not necessarily provide full assurance’.
In the case of Japan, long term inflation expectations turned out to be systematically wrong. Inflation expectations for 6 to 10 years in the future only declined gradually in the early 1990’s and they actually remained positive throughout the last two decades. However, the real outcome throughout this period was that Japan experienced a continuing fall in price levels. So, the ECB’s argument of long term inflation expectations remaining firmly anchored turns out to be pretty worthless.
- Econometric models are an unreliable guide for the future if the structures of the economy have changed. This message is hidden in the following paragraph: “The sensitivity of the inflation outlook to shocks appears to have increased (…). Reduction in nominal rigidities in some Member States may well have reduced some of the downwards stickiness that inflation in the Euro Area experienced at low levels in the past”.
Here the crucial point to note is that wage formation and collective bargaining institutions have been dismantled in a number of Euro Area member states in recent years. However, it is the existence of these institutions that has prevented wages and prices from ‘falling through the floor’ in the past. Now that these safeguards against downwards wage and price developments have largely disappeared, economies have become much more vulnerable to disinflationary shocks. The risk of deflation has therefore become much bigger than one would suspect on the basis of econometric models which are necessarily based on past events and past data. In other words, the danger of moving into a deflation regime cannot be reduced to a so-called ‘tail risk’. If recent structural reforms of wage formation systems are being taken into account, it has actually become a clear and present danger.
- The danger is not just deflation, simply too low inflation will do the job of dragging the economy down.
“A protracted period of very low inflation increases the real value of both public and private debt and results in higher real interest rates, making the ongoing internal adjustment in a number of Member States more difficult”.
So, gone is the traditional view that falling prices are per definition a good thing since they improve competitiveness. The Commission is instead paying attention to the danger of low inflation pushing up the real burden of debt. This forces all economic actors (governments, households, companies) to service nominally rigid debts from falling nominal revenue. In this process, even more demand gets squeezed out of the economy, which in turn works to intensify disinflationary pressures further.
Conclusion: A small step for European trade unions, a giant leap for DG ECFIN.
For trade union economists, none of this is new. These are exactly the things they have repeatedly been warning of (see for example here). The fact that the Commission, and DG ECFIN in particular, now seems to be sharing some of the same concerns is interesting. So could it be that there is still hope after all for the sanity of economic policy-making in the Euro Area? The reply to that question depends of course on the reaction from the ECB. Let us hope that DG ECFIN, in the political fight behind closed doors that will follow after this publication, will stick to their guns.