Deflation: Symptom or disease?

Today, Italian media published the news that prices in January were 0.6% lower than a year ago, calling such deflation a disease, a contagion. The fact that a component of deflation is the falling price of oil should be good news for an oil-importing country such as Italy. But no! National TV (RAI) insists that deflation is a nightmare, and other media wish for inflation to come back thanks to Draghi’s QE.

Some call deflation a national emergency and yet, they seem to have a hard time explaining why prices getting lower is such bad news. Indeed, it seems that they can’t explain it, at least not until they no longer confuse the symptom for the disease.

One explanation they give is that deflation means lower GDP at current prices, and this makes the Debt/GDP ratio look bad. This should speak for how foolish the Debt/GDP rule is, rather than be a real cause for concern. To me, bad news is any economic indicator that tells me something bad is happening to the real standard of living of people. Unemployment at 13.4%, and youth unemployment at 43.9%: Let’s talk about this nightmare (not to speak of Greece’s nightmare squared).

Another explanation is truly peculiar (but well known to economists who are familiar with the expectations hypothesis). In such a view, deflation is bad because consumers expecting falling prices postpone their spending and cause the current prolonged stagnation. Well, actually, if Italy’s deflation were caused only by falling oil prices, there would be reason to celebrate, and no reason why the ECB should want to take us back to 2%, except another foolish rule. If the VAT were cut by 50%, deflation would get even bigger, at least for a one-time adjustment. Yet, consumers would be much better off.

Deflation is a symptom

When domestic prices fall because imports like oil get cheaper, deflation is a (good) signal of better terms of trade. No nightmare, no contagion. Italy’s current deflation partly reflects this positive (to Italy) opportunity.

Current Italian deflation is a problem because it reflects the fact that wages are stagnant, and wages are stagnant because demand is stagnant, and demand is stagnant because private debt is not capable of funding investment, and public debt is prevented (by the Debt/GDP rule discussed above) from doing so.

Is QE forever?

The point of Draghi’s QE is not the amount. It is the principle.

It is not the much discussed size of the ECB operation. Rather, it is the fact that the ECB has become a buyer of government bonds issued in the countries that are members of the Eurozone.

This is the really big news in the Eurozone where, until last week, the ECB’s monetary operations did not include the possibility of trading in the government securities market in the same way the Fed, the Bank of England, or the Bank of Japan do.

With QE, the ECB has become an actor in the government securities market and, as happens in the U.S,, the U.K., or Japan, this provides continuous liquidity to the bonds being traded, removing default risk.

The ECB could have achieved this same goal without QE, simply by announcing that it would enter the government securities market in its monetary policy operations. Technical and political circumstances were such that Draghi achieved this same result through an operation called an expanded asset purchase programme. While Draghi sold this program as being inflationary (meaning, it will help restore a below-but-close-to 2% inflation rate), in fact it is not (the ECB will spend 60 bn euros each month to buy 60 bn euros of private and government securities), and yet what really matters and what makes Draghi’s QE announcement historical is the fact that the ECB has become an actor in the government securities market of the Eurozone.

Because Draghi’s QE removes default risk from government debt, deposit insurance (now funded at the national level) becomes more credible, and TARGET2 imbalances will get smaller.

QE will not last forever. But the new attribute of the ECB as a dealer in government bonds is here to stay.

Swiss franc cap policy gone. Now what?

The single truth and sure result of last week’s SNB move is that, from now on, the value of the Swiss franc will be the outcome of “market forces”.

Any policy aimed at lowering the national currency value (and thus its purchasing power for foreign products) is justified to support exporters. It is not the right policy for increasing national employment and living standards. As far as the public interest of Switzerland goes, there is no reason to cry over Thomas Jordan’s decision. (If you had borrowed Swiss francs massively to invest into dollars or euros, that is your problem.)

The SNB also lowered interest rates further down into negative territory. And this is more problematic to the well-being of Switzerland. Negative rates are no stimulus to the economy. A negative rate is a tax on banks and their clients and has a contractionary effect on demand, incomes, and jobs.

It is now too early to judge where the market-determined value of the Swiss franc will go. It is possible that once all the hedged positions around the world are cleared, it will stabilize not too far from where it was.

But in case it doesn’t, and the Swiss franc remains 15-20% more expensive on currency markets with big negative rates, Swiss producers are likely to face a drop in sales of some consequence. An increase in domestic demand is thus needed to prevent a decline of incomes and jobs in Switzerland.

The economics of the flow-of-funds tell us that this can only happen in conjunction with a further increase of either private or public debt. Given concerns with high household debt in Switzerland, a policy that removes the debt brake from public investment in infrastructure looks the most attractive approach for enhancing employment, incomes, and productivity.

Searching hard for Taylor’s inflation

In February 2011, I was in the audience of a lecture given by John Taylor on the “exit strategy”. One main theme was that the policy of the Fed called “Quantitative Easing” meant a high risk of monetization and inflation, if not hyper-inflation, in the U.S. economy. In the Q&A session, I asked Professor Taylor why he thought that “monetization” is inflationary. I argued that Quantitative Easing boils down to portfolio shifts in banks’ balance sheets, and that asset reallocation does not seem to be causing an increase in demand, nor a price increase. Continue reading

Letter to The Economist

SIR – You described the ECB as moving forward at “breakneck speed”, while businesses and workers in the Eurozone are not doing likewise (“Busy, busy”, September 4th). But more should be said about the trajectory along which the ECB seems to be advancing so quickly. As the ECB embarks on QE, you note that the ABS market is “simply too small” to boost growth and the sovereign bond market, while large enough, is politically unfeasible.

I would raise a more fundamental question: What does the ECB expect to achieve by removing (from banks’ balance sheets) assets carrying positive yield and replacing them with “reserves” (that now yield a minus 0.2%)?

The notion that QE encourages bank lending and that reserves multiply into bank loans is flawed. A number of academic and practitioner articles have dispelled the myths surrounding money creation and QE. If this is true, then the ECB may be moving at “breakneck speed” toward a brick wall.

Negative EONIA rates are not *cracks* in the banking system

From Reuters: UPDATE 3-Negative euro overnight rates show cracks in banking system

While there are many signs of cracks in the Eurozone, European banks “paying” negative rates to other banks for lending money is not one of those. It is simply the profit-maximizing consequence of the ECB’s decision to charge banks for any reserves above the required minimum.

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Fiscal responsibility means quality spending and the “right” deficit

A response to Steve Hanke’s defense of austerity

Since the outcome of the European elections, political leaders in the EU’s most stagnating countries have been calling for an end to austerity. While they seem unable to develop a realistic and politically palatable alternative, Europe remains in the doldrums, and pro-austerity views are having a comeback. One such example is Professor Steve Hanke’s defense of austerity (in “The EU’s Anti-Austerity Hypocrites” which aims at reasonable objectives with the wrong tools.

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ECB drives rates below 0.05%: And now what?

The move of the ECB on June 5 was primarily aimed at restoring conditions of low and stable money market rates.

It was not difficult to predict (as I did here six weeks ago) the direct consequences of the new official rates and, notably, of the prolongation of fixed rate, full allotment tender procedures, and of the decision to suspend the weekly fine-tuning operation sterilising the liquidity injected under the Securities Markets Programme.

Except for the end-of-June spike, money market rates appear more stable and lower.


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