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Who’s afraid of eurozone deflation?

Published in Business Spectator (Melbourne), 15 January 2015

Usually, we call things stable when they do not change and unstable if they do. Apparently this is not the case in monetary policy.

A minute annual decline of consumer prices by 0.2 per cent in December, a rounding error really, is sending Europe’s central bankers into panic mode. Meanwhile, the same bankers regard price increases of 2 per cent not only as desirable but as an indication of stability.

Over and over again, the European Central Bank and its President Mario Draghi have reiterated their ‘2 per cent price increases equal price stability’ mantra that it has become almost universally accepted. But constant repetition cannot not turn this lie into the truth.

The first problem with Draghi’s 2 per cent inflation target is a legal one. Article 127 of the Lisbon Treaty, which governs the workings of the European Union and its institutions, is quite clear: “The primary objective of the European System of Central Banks shall be to maintain price stability.”

Given that price stability is thus defined as the most important targets for the ECB, it may be surprising that the Treaty does not define what is meant by stability. If treaty law does not specify such terms, one would normally assume that a dictionary definition applies. Not so in this case. It was the ECB itself which took the Treaty term to give it a new meaning.

On its website, the ECB informs the public that the ECB’s Governing Council has announced a quantitative definition of price stability: “Price stability is defined as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2 per cent.” The Governing Council has also clarified that, in the pursuit of price stability, it aims to maintain inflation rates below, but close to, 2 per cent over the medium term.

Some economists might even agree that 2 per cent price increases are preferable over actual price stability. However, this does not alter the fact that the 2 per cent figure is not mandated by the Treaty establishing the ECB. Instead, it is an arbitrary figure plucked out of thin air. The ECB could have equally taken 3, 4 or even 10 per cent and defined them as ‘stability’ (or -3, -4 and -10 per cent).

The ECB is supposed to act independently within its mandate, which makes good sense. But should it also have the freedom to define its mandate?

Apart from this admittedly legalistic critique, there are more substantial problems with the ECB’s insistence that the general price level should be increasing by 2 per cent every year. The main argument typically levelled against falling prices goes something like this: Once prices start to fall, consumers will become more reluctant and wait for better bargains in the future. In fact, Mario Draghi himself has used this argument in the past to warn of the dangers of deflation.

There is only one problem with this postponed consumption hypothesis. It is not true.

As consumers, we instinctively know what happens when things get cheaper: we buy more of them. Decades of falling prices for TV sets, mobile phones, computers and other gadgets have not reduced our demand for consumer electronics. We do not hold off buying a new smartphone today just because next year’s model is likely to be better and cheaper.

Such observations are confirmed in a recent working paper published by the Kiel Institute for the World Economy. Analysing consumption patterns and price changes across a variety of consumer goods, economists Henning Klodt and Anna Hartmann demonstrated that falling prices tend to stimulate the market. Their conclusion was that deflation does not postpone consumption decisions for individual product categories. This makes it hard to believe that at a macroeconomic level, a falling price level would have a negative impact on aggregate demand. The authors therefore recommended that central bankers should remain relaxed at the prospect of falling prices.

Looking at the driving forces behind Europe’s minor dip into deflation territory should actually reduce central bankers’ fears even more. The main reason for a slightly lower price level is declining energy costs, especially for oil and gas.

Since Europe imports a lot of these fuels from non-EU countries (particularly Russia and OPEC countries), lower energy prices act as a stimulant for the European economy but are certainly nothing to worry about.

There is only one valid reason why the ECB might be concerned about a slightly falling price level. Falling prices have an unpleasant denominator effect for debtors. Inflation helps debtors to deal with their debt load as it melts away a fraction of their liabilities. Deflation does the opposite. It aggravates any debt problems because past debt becomes larger in real terms when prices fall.

Put simply, inflation is a process which redistributes wealth from creditors to debtors whereas deflation reallocates wealth from debtors to creditors. If the ECB is panicking about deflation, it thus shows whose side it is on.

By demonising ‘deflation’ (even if it is really just price stability by another name), the ECB underlines its commitment to helping the eurozone’s debtors, whether they are financial institutions or governments. The response to this so-called deflation threat will be to maintain interest rates negative or even embark on a program of quantitative easing, which may be announced over the coming days. In effect, however, such policies are just bailout programs by stealth.

Of course, the ECB maintains the pretence that what it was doing was monetary policy. But bailing out debtors has as much to do with monetary policy as a 2 per cent increase in consumer prices has to do with price stability.

The first casualty when war comes is truth. In the ECB’s war on Europe’s debt crisis, it is no different.

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