The European Central Bank appears poised to mimic its counterparts in the US, Japan and Britain by pumping billions into its financial system to fight deflation and inject some life into its listless economy. But the move is unlikely to achieve much beyond worsening uncertainty, lining the pockets of the well off, and discouraging European governments from mending their ways.
It is not even certain the mild deflation that is compelling the ECB to act foreshadows the economic disaster feared. The fact that aggregate European prices have fallen 0.2 per cent over 2014 is as much a relief for workers as it is a burden for borrowers. For most, cheaper bread, rent and petrol leave more money to buy other goods and services.
Sure, deflation exacerbates European governments’ debt burden, but it also helps reverse the decay of lower and middle-class real incomes that has been sapping growth in the developed world for more than a decade.
Inflation, by contrast, typically suits the wealthy who disproportionately benefit from capital gains and have access to sophisticated advice and financial instruments to profit from a rise in prices. Deflation isn’t all bad: it creates winners and losers.
To be sure, the Great Depression showed deflation induced by a collapse in the money supply is disastrous and should be resisted, but prices routinely fell in the 19th century without economic armageddon. In any case, this isn’t happening in the eurozone: the money supply including cash and deposits at banks (M3) has risen steadily since the financial crisis and by around 4 per cent last year to €10.2 trillion ($14.6 trillion).
Assuming it surmounts constitutional difficulties, the ECB plans to buy about €600 billion of European government bonds over the next 12 months, or around 6 per cent of the total outstanding stock of the 18 governments that use the euro. This is unlikely to be effective at boosting deflation.
To make such purchases the ECB credits its liabilities with newly created money (this is the controversial “money printing” part) at zero cost to itself, and simultaneously credits its assets with purchased government bonds. The extra demand for bonds is meant to increase their price, reduce their yield and cause interest rates to fall. In turn, lower interest rates are meant to encourage businesses to borrow and invest.
But European rates are already low. Yields on 10-year Spanish and Italian bonds are below 2 per cent (below AAA-rated commonwealth government bonds), while those on safer German and French bonds are around 0.6 per cent and 0.9 per cent, respectively. Yields cannot be negative (otherwise people would keep their money under the bed), so it is hard to see how QE can drag them down much further.
To the extent QE does curb upward pressure on bond yields, it reduces the pressure European governments face to foster genuine growth by deregulating their labour and product markets.
In any case, investors don’t seem to believe the ECB will achieve its stated inflation target of 2 per cent a year. If they did, then yields on governments bonds imply investors are embracing capital losses on their investments -- it would make more sense to hold physical cash. The more likely explanation is investors are expecting sustained deflation to ensure a modest real return.
Advocates of QE point to Japan, which has endured bouts of deflation since its economy imploded in 1990. But its woes have been exaggerated, its meagre growth rate bandied about in horror without adjusting for its rapidly falling population. Moreover throughout it maintained a low unemployment rate and its people remain wealthy: the Japanese government’s huge debt is owed almost entirely to its own citizens, and collectively, the Japanese enjoy the biggest net foreign asset position in the world.
No advanced country is likely to experience deflation for too long. While it was common under the gold standard of previous times, it isn’t the natural state for fiat currencies. This is because the notes, coins and the little dots on a screen we use to pay for goods, services and assets are inherently worthless. A $50 note is only worth so much because enough people think it is, therefore its value measured against real goods and services tends towards zero.
Governments can in theory create price inflation quickly if they truly want to: simply print so much money and hand it out randomly until households and businesses freak out and inflation starts to soar. Certainly the financial services sector would not favour this ‘helicopter drop’ of newly printed cash. Through QE as practised banks benefit from increased bond trading commissions, asset management fees and the benefits that an influx of cash from the central bank bestows.
This article was first published in The Australian. Reproduced with permission.