Synopsis: The effects of and solutions to deflation.

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Discussion:

This article discusses the effects of and the lack of potential solutions to the current worldwide deflation.

Christopher Sims, a Nobel laureate who specialises in causality in macroeconomics (quoted in this article) warns that QE by itself has little effect on monetary patterns, and thus, on inflation. He says that the only reason Anglo-Saxon QE worked at all is because the central banks (BoE and the Fed) “talks a better game” (which, in its essence, is qualitative easing) than the ECB.

The effects of deflation are:

1) Pre-emptive retrenching, given consumer expectations for prices to decrease.

2) Decreased investments and increased savings from businesses who expect a hit.

Overall, the two points above mean that there will be less money circulating the economy. Notice how those two points show that an expectation of deflation causes deflation – these two reasons are the main reasons why deflation is a self-fulfilling prophecy.

Whether QE works to increase deflation can be seen by observing Japan, whose large-scale bond-buying programme is meant to encourage inflation.

Key words:

1) Money indicators: money indicators measure the amount of money in an economy. Different definitions of money supply include cash, or cash and deposits, or checks.

These definitions, according to Investopedia, are:
a) M0: Hard cash and coins
b) M1: M0 + checking accounts, traveller's checks, demand deposits
c) M2: M1 + savings accounts, time deposits (less than $100,000), money market funds

2) Primary surplus: This is where government income – government expenditure > 0 but the interest on the loan has not been paid back yet. For another blog post that discusses the primary surplus, click here.

Context:

What is Sims referring to when he says that the Fed “talks a better game” than the ECB? This is the idea of qualitative easing (more can be read about this here), where the Fed assured the economy that it will do its best to decrease unemployment and increase inflation, i.e. they said that they would carry QE through to the end. I disagree that the ECB doesn’t “talk a good game”. In fact, in 2012, Draghi said that the ECB will “do whatever it takes” to improve the economy. In 2012, many people believed that the periphery Eurozone countries would split from the EU. As a result, borrowing rates for the PIGS countries increased, and confidence in the euro was lost. Draghi responded by saying that the ECB would do "whatever it takes" to save the euro. Because of this, the faith in the Euro was restored and the borrowing rates for the periphery countries dropped. Click here to read the official statement made by Draghi.

Synopsis:  The ECB and how it avoids QE.

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Discussion:

This article discusses the fact that the ECB is taking negligible steps towards helping the Eurozone economy in terms of monetary policy.

The ECB is facing major opposition from Germany, which fears that the launch of large-scale and proper QE might result in uncontrollable hyperinflation – a repeat of pre-World War 2 German economy.

As opposed to the QE that was used by the Fed and is being used by the BoJ, the ECB is instead enacting ‘penance’ measures – more to put up a show rather than to improve the economy, according to Pritchard.

Mr. Mario Draghi, the head of the ECB, has hinted at a EUR 1tn spend. As much as it sounds similar to QE, it is not, for two major reasons:

1) Central banks that enact QE take the risk on their own balance sheet; this is to say, whatever happens to the value of the sovereign bonds they purchase, they deal with it. Instead of doing so, they are offering LTROs (explained in the article) to banks in exchange for collateral.

2) The ECB is spending nowhere near the EUR 1tn promise – rather, its spending amounts to about EUR 450bn, perhaps lower. This equates to roughly EUR 17.5bn a month (and this spending will not start until the end of the year), 10 times less than the spending by the Bank of Japan.

Many economists also say that the lowered interest rates will have a negligible effect on the overall market at this point, i.e. conventional expansionary monetary policy just does not work for the Eurozone as of now.

Key terms:

1) Deleveraging: Where banks lower the amount lent to the public so that banks can keep up with the capital adequacy ratio.

2) Capital adequacy ratios: To protect bank depositors, governments have come up with this concept. The idea is that a bank must have a certain amount of capital in its bank, so that if the bank incurs losses and cannot pay depositors back, the banks can use some of its own capital to cover the losses. Usually, when capital adequacy ratios are discussed, the Basel rules are mentioned as well. These rules (Basel I, Basel II and Basel III) dictate the amount of capital needed in the banks. The more, the better for the depositors.

Context:

One thing worth discussing is the sixteenth paragraph: “Nor is it clear… said Mr. Roberts from RBS”. The statement being made here is that unless the ECB takes on bad bonds, there is no point in bothering with QE in the EU. The problem with this statement is that no economy that has practiced or is practicing QE (Japan, USA and UK) has taken on bad bonds; they have only ever taken sovereign (government) bonds. Government bonds are steady and trustworthy, and very reliable bonds to purchase. For a long time, the government and the central bank of a country have been split, where it is the government’s job to take on bad loans and liquidate frozen banks. The central bank has two objectives: to maintain steady and reasonable inflation, and to reduce unemployment. If an economy were to be taking on “bad stuff”, as Mr. Roberts from RBS (quoted in that paragraph) says, it would be only from the part of the individual governments, not the ECB.

Synopsis: What are the problems with deflation and what must we be watching out for now?

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Discussion:

This article discusses the dangers of deflation and what we must expect from deflation today. After two generations of persistent inflation, it almost seems as though the lack of inflation today is not to be a source of worry at all, when, in fact, it should be.

America, Britain and the Eurozone are struggling to meet their target inflation, while some countries in the periphery of the Eurozone, i.e. the PIGS countries, have slipped into deflation.

One problem with deflation is that it is a self-fulfilling prophecy: if consumers believe that goods will be cheaper in the future, they will not spend now, choking consumption. If investors believe that the money they make in the future by investing now will be worth less than today’s currency, they will not invest. A lack of consumption and investment encourages deflation. As wages and incomes fall, the real value of debts will increase due to deflation.

The beginning of this deflation was the drop in oil prices. The drop in prices was because of an increase in global supply of oil by the U.S., and a decrease of global demand in oil by China, whose economy is slowing down. Generally, a fall in oil prices is celebrated; it is like a tax cut for oil importers. It is estimated to boost global growth by 0.4 percentage points.

This decrease in global demand, however, poses real problems worldwide. Inflation expectations in America, Europe and Japan have been slipping lower and lower.

There are some instances where deflation is a good sign. This is when prices drop due to a decrease in cost of production, i.e. an increase in productivity. Such “good deflation” happened to the world when they still followed the gold standard. Michael Bordo and Andrew Filardo, two economic historians quoted in this article, say that America faced such “good deflations” during the 1880’s, during which time output rose by 2%-3%.

Bad deflation, on the other hand, happens when there is an output gap, i.e. demand is lower than potential supply. The result is large layoffs across the economy, increasing unemployment. Again, the real value of debt increases, which stifles consumption and investment, increasing deflation. Such a trap is called debt deflation. An example of debt deflation is in Germany, pre-WW2, a period classified mostly by Germany’s hyperinflation.

We see this bad deflation happening now. As high inflation was squeezed out of the global economy, the fear of deflation dissipated in everybody’s mind, until Japan’s economic bubble burst, slipping the economy into deflation. Japan’s economy was choking with bad debt. Economists were shocked that Japan actually slipped into deflation, as opposed to persevering with low inflation. We can see a similar assumption being made today worldwide. However, even if the world does face low inflation as opposed to deflation, the consequences are equally as severe.

Low inflation (lower than the inflation target of economies) encourages unemployment once again. Furthermore, lowflation (low inflation) in the Eurozone means deflation proper for the PIGS countries. These countries are forced to resort to internal devaluation (for more on internal devaluation, see this blog post), which exacerbates deflation.

Whether economies are facing deflation or low inflation, debt to GDP ratios are on the rise due to the lack of inflation, a ratio which was a factor in Greece’s eventual default in the Eurozone.

Secular stagnation, a phenomenon where economies need negative real interest rates to achieve full employment, becomes a very real fear as consumption and investment slow down.

In the EU, where deflation is a great problem, especially for the periphery countries, Draghi is unable to use monetary policy to alleviate the problem, facing opposition from Germany. Because of this, the euro is not being devalued. After the end of QE in America, neither is the dollar. These high exchange rates stifle exports and hence, production, exacerbating deflation.

It is no question that actual QE is needed in the Eurozone, and greater expansionary fiscal policy is needed in America (as well as in Japan!).

While these measures seem obvious, political opposition to this is abundant. They argue that it will cause debt to rise, a measure that will have to be addressed by future generations, and might cause another economic crisis.

Context:
What is an output gap? It is when the economy is not producing at its fullest potential. It can be explained by this diagram:

If an economy is producing at point A, its output gap is B-A. Only once it moves to point B can the economy grow, at which point the output will increase from B to C.