Deflation: why worry?

Should we worry that the euro zone is in deflation (pdf)? Certainly, deflation is a symptom of a severe problem - that of weak demand which has resulted in almost one-in-four (pdf) young people being out of work. And the very fact that deflation is unfamiliar might create uncertainty which itself is bad for economic activity. Beyond this, however, I suspect that what we have to fear is not so much deflation as bad policy.

For one thing - as Robert Peston points out - the fall in the CPI is entirely due to lower oil prices, which should raise real incomes and activity. (Note, though that even excluding energy inflation is only 0.6 per cent, which is well below the ECB's target of "below, but close to, 2%." In this sense, there has been a failure of economic policy.)

And for another thing, history tells us that deflation needn't lead to weaker growth. My chart plots GDP growth against inflation in the previous year for the UK before WWII - a period when deflation was common. You can see that, if anything, deflation led to faster growth than did inflation. Of course, there are many differences between 19th Century England and the euro zone today (though maybe not so many in Germany), but this historical evidence suffices to tell us that there is no necessary, inherent reason why deflation must lead to worse economic performance.

All this said, there is a danger here. It lies in the dynamics of government debt. Remember the simple equation which tells us what primary budget balance governments must run to stabilize the debt-GDP ratio. It is:     

d * [^(r-g)/_(1+g)]

where d is the debt-GDP ratio, r the nominal interest rate and g the nominal growth rate.

This equation tells us that if g falls relative to r, then more fiscal austerity is needed to stablize the debt ratio. And such a fall is quite possible if (for example) permanently lower inflation is accompanied by markets worrying about debt sustainability, which would keep bond yields high.

This poses the danger of a vicious circle in which deflation leads to austerity which leads to further deficient demand and deflation.

What could prevent this? In theory, the mere existence of the inflation target should do so; this should keep inflation steady at just under 2%. What's in doubt, though, is whether the ECB can or will achieve this. In this sense, calls for a higher inflation target, whilst perhaps reasonable in other contexts, aren't (yet) relevant; the ECB's not hitting its current target, let alone a higher one.

Instead, there are two other possibilities. One, of course, is full-blown QE. Sure, it's doubtful how much this will raise activity and inflation. But even so, it has another virtue. It would hold down bond yields and so help prevent the rise in r - g that would worsen debt dynamics. In this sense, QE is a form of fiscal policy.

Ah, yes - fiscal policy. The solution to deflation at the zero bound is simply a looser fiscal policy. And, taking the euro zone as a whole, there is plenty of room for this; the OECD estimates that the region is running a surplus on its underlying primary balance.

It is, however, unlikely that this option will be exercised. Which is why I say that the biggest danger for the region isn't so much deflation as bad policy. 

Comments

[Luis Enrique]

yep. when we had inflation caused by oil / terms of trade we were rightly told to ignore it. Same should hold.

same (similar?) point above govt debt applies to other debts. here is Tim Harford: " Low inflation means that a 30-year mortgage really is a 30-year mortgage rather than five years of hell followed by an extended payment holiday. "

http://timharford.com/2014/11/why-a-house-price-bubble-means-trouble/

[Carol]

So, Luis, we should simply ignore unemployment, increasing poverty etc? And the fact that 30 year mortgages will get more and more expensive relative to their original costs? You are bizarre.

[Luis Enrique]

Carol,

there is a difference between inflation (and deflation) caused by movements in prices like oil, or exchange rate shifts etc., which if not exactly one-off is not the sort of thing that happens year after year, and inflation (or deflation) that reflects prices being adjusted across the economy, including wages, which can be self-perpetuating. I think the first point Chris makes is that we are probably seeing the former, not the latter. If so, then the argument for ignoring that sort of inflation also holds for deflation.

So I think you misinterpreted what I meant. Even so, it's quite a (bizarre) leap you thinking I'd ignore deflation to supposing I'd ignore unemployment and poverty.

The second para of my comment suggest that persistent low inflation (or deflation) certainly should not be ignored, at least as far as debt dynamics go.

[Ralph Musgrave]

I don’t agree with the widely held assumption, which Chris seems to accept, namely that to cut the debt, austerity is needed. To cut the debt, all we need do is print money and buy back chunks of debt: i.e. implement QE.

And if that proves too stimulatory / inflationary we just raise taxes and “unprint” the money collected. As long as the DEFLATIONARY effect of the latter equals the INFLATIONARY effect of the QE, the net effect on GDP is zero. I.e. no austerity is involved.

That “no austerity” point is certainly valid in the simple case of a closed economy. In contrast, in an open economy, i.e. where foreigners hold a significant proportion of the debt, the above QE involves a certain amount of “repaying foreign creditors”, and that means a standard of living hit. But I’m not moved to tears by that: no long term harm ever came from paying off one’s creditors.

[Nick]

QE is not a solution since it helps only asset holders and as seen in UK it has distorted the asset prices.

Basic Income is the only solution.

[Ralph Musgrave]

Nick,

The vast majority of QE (about 99% in the UK) involved buying government debt, not other assets. Obviously that in itself will raise asset prices. But that’s to fail to see the wood for the trees. In other words the really important question is: what’s the OVERALL effect of the state incurring debt and then buying back that debt?

The INITIAL effect of the state borrowing rather than raising taxes will be to REDUCE the price of other assets. So when the state QEs its own debt, I’d guess the net effect on other assets will be roughly neutral.

Re basic income, that might well be a good idea, but it doesn’t have much to do with the above arguments put by Chris.

[ccz1]

Wild deflation in Portugal married with highest increase in November retail sales in eurozone. Go figure!