Europe is in the clasp of the deflationary forces that resulted directly from its inane handling of the Eurozone crisis. In this interview, I discuss deflation and low-flation and suggest a particular form of quantitative easing that, unlike the Fed’s of the Bank of England’s QE, will not reinflate the bubbles of the financial sector but, instead, will help recycle idle savings into productive investments in Europe’s real economy.
1. Is a deflationary spiral a true risk for the Eurozone (IMF-WEO referred to a 20% probability until end of 2014)? Or would it be correct to say that we are in a state of low-flation mainly due to temporary ‘imported disinflation’?
The Eurozone is already in the clasp of powerful deflationary forces. In the Periphery, the debt-deflationary cycle remains in full swing. If GDP seems to be stabilising (e.g. Greece), or even recovering slightly (e.g. Spain), this is due to the statisticians (correctly) anticipating price deflation. These deflationary expectations mean that a further reduction in nominal GDP ‘translates’ into an anticipated… increase in real GDP (or GDP at constant prices) as long as prices fall faster than nominal GDP. This is why the statisticians are predicting ‘recovery’: Recovery in real GDP terms which, in reality, is a drop in nominal GDP that appears like recovery due to…deflation.
Turning to core, surplus Eurozone countries, ‘low-flation’ is produced endogenously, rather than being imported. To see that this is so, just decompose the GDP of the Netherlands, Finland and Germany. One look at the decomposed data confirms that these economies are suffering from weak internal aggregate demand, which is then reinforced by the reduction in the prices of their goods and services both in the European Periphery and beyond.
Faced with this ominous situation, Europe’s authorities are, once more, interested in one thing only: how to hide the problem under the carpet. For example, the European Banking Authority just announced that the forthcoming stress tests (to be conducted by the European Central Bank) will be based on a number of adverse scenaria not including, however, the threat of deflation. Reuters quoted an analyst suggesting that including a deflationary scenario would be bad for morale because of the devastating impact it would have on public and private sector balance sheets. So, in its infinite wisdom, Europe is adopting the ostrich strategy, burying its head in the sand (assuming that deflation will just go away) and offering inane excuses about the deflationary forces observed as we speak.
One such excuse is that deflation and low-flation is due to the strong euro, and can thus be attributed to ‘imported disinflation’. It is an absurd excuse since the euro’s strength is the direct result of the expanding Eurozone-wide current account surplus which, in turn, is due to Europe’s commitment to austerian fiscal policies at a time when savings exceed investment by a wide margin. While the maintenance of a tight monetary policy, by an ECB unable or unwilling to act, is part of the problem, the main cause of the deflationary phenomenon is Europe’s response to the crisis: the mix of universal austerity and huge loans to insolvent states and banks.
In short, Europe, and the Eurozone in particular, are buffeted by deflationary forces which are the direct result of the particular policy mix that emanates from Berlin and which the other governments have consented to. Now that it is impossible to deny it, Europe’s top echelons are blaming it on the rest of the world, like children caught doing naughty deeds.
2. Is deflation in peripheral Eurozone countries under ‘internal devaluation’ processes necessary? Will it have an impact on the overall eurozone?
In our monetary union, the lack of
• a substantial mechanism for recycling surpluses during a crisis from the surplus regions or states to the deficit ones, and
• a mechanism for deep debt restructuring,
ensure that, after the crisis, the burden of adjustment falls on the regions or states that are least able to withstand it. The result is wholesale depression in these regions or states which, inescapably, reduces aggregate demand in the surplus regions or states, unleashing deflationary forces throughout the monetary union. This is what happened after 1929 to the countries participating in the Gold Standard and it is what is happening in the Eurozone, whose monetary and economic union is a throwback to that Gold Standard.
3. Are historical memories of deflation during the Great Depression, and in Japan in more recent decades, benchmark examples that call for bold monetary action in the Eurozone?
We should have learnt our lessons years ago. The very design of the Eurozone was based on the Gold Standard model. Before the crisis, it encouraged a frenzy of capital flows from the surplus to the deficit countries, which created the bubbles in Spain, Ireland, Greece etc., which then burst causing the crisis. The crisis then led to a vicious reversal of capital flows (from the deficit to the surplus countries), which engendered depression in the Periphery and a deflationary posture throughout the Eurozone. This is what happened after 1929 in the Gold Standard and it is what also happened in the Eurozone after 2008. One wonders why European officials expected anything else, given that they had designed the Eurozone in the image of the Gold Standard. One also wonders why, for six years now, they sit idly by, watching this disaster unfold with the ECB doing virtually nothing.
4. Might all this talk of deflation be a way to press the ECB into larger liquidity injections in favor of European core banks and indirectly to Eurozone sovereign bond purchases, particularly peripheral ones? Could this be part of a strategy to create new bubbles in other financial markets?
Possibly. But, this should not be what we are pressing the ECB to do. The problem is not one of liquidity. And the solution should not be new bubbles.
The ECB did provide massive liquidity to the banks, e.g. under the LTRO, and that did nothing to help, except to buy some extra time for policy makers to get their act together (which they never did!). The aim now should not be to reflate the toxic bubbles by means of quantitative easing, either in the Periphery or in the core countries. The idea discussed currently in Frankfurt, of helping expand the structured derivatives market (bundling SME loans from the Periphery in these derivatives) and then have the ECB buy these ‘products’, is utterly absurd, unproductive and downright dangerous. We need a simple, logical, effective and, yes, virtuous form of quantitative easing. Here is an idea:
The European Council could authorise the European Investment Bank and the European Investment Fund to embark upon a large investment-led recovery program for the whole of the Eurozone, to the tune of 8% of Eurozone GDP. This can be fully financed by net bonds issues by the European Investment Bank, waiving the stipulation of matching funds from the member-states (national contributions). Instead, so as to ensure that the value of these bonds remains high (and their yields low), the ECB could immediately begin a large purchase program of these EIB bonds in the secondary market, to a tune necessary to keep their prices above a certain level. This way, the ECB’s quantitative easing will support proper investments directly into Europe’s real economy and will not have to deal with the problem (that is currently baffling the ECB council’s members) of which bonds or loans (and their nationality) to buy. EIB bonds are triple-A eurobonds (i.e. bonds issued on behalf of the whole of Europe) and, therefore, eminently acceptable paper assets for Europe’s central bank to buy.
5. What are the probabilities that the ECB will move ahead in the next May 8 meeting?
Depressingly low.
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