A dose of inflation would help the eurozone medicine go down

Everyone accepts that persistently high inflation can damage economic growth and arbitrarily punish some groups in society while benefiting others. But in Europe at least, the risks of excessively low inflation are often ignored. In the face of chronically weak demand, the eurozone now faces the prospect of deflation. This promises to depress economic growth further and make it yet harder to pay down debt. Indeed, the role of higher inflation in helping to address the eurozone crisis is poorly understood. If the single currency is to survive, it needs much higher inflation than at present, especially in Germany.

Policy-makers are right to warn of the risks of losing control over inflation. Persistently high and volatile inflation can make it hard for firms to calculate prices and future profits, deterring them from investing. It can create wage spirals and, crucially, redistribute income from savers to borrowers. But eurozone policy-makers are dangerously sanguine about the risks of low inflation. When inflation falls very low, consumers and firms tend to sit on cash rather than spend it, in the case of consumers because they expect prices to fall further or in the case of firms because they fear a further weakening of demand. This is what economists mean by a ‘liquidity trap’: households do not want to spend and firms do not want to invest, making a prolonged recession self-fulfilling. Meanwhile, very weak growth and low inflation make it much harder to pay down debt. The US and most of Europe spent much of the 1930s in such a liquidity trap, and after spending the last 20 years in one, Japan is now desperately trying to escape it. If the eurozone is not to get caught in such a vicious circle, it will need to rapidly stimulate its economy.

Headline eurozone inflation turned negative over the second half of 2009, before rebounding and averaging almost 3 per cent over the second half 2011, and hence well above the ECB’s target of ‘close to 2 per cent’. The apparent strength of inflation was used to rebut those who argued that the eurozone needed lower interest rates and more fiscal stimulus to counter the downturn. Such policies, it was argued, would lead to unacceptably high inflation. For example, the ECB persistently used above target inflation to justify its refusal to cut interest rates further or launch unorthodox forms of monetary stimulus such as quantitative easing (QE). This refers to the practice of central banks purchasing financial assets from commercial banks and other private institutions. But much of the inflation over this period reflected higher energy (and food prices) and crucially, increases in administered prices and value-added-tax (as governments have attempted to get on top of fiscal deficits). In reality, the headline rate of inflation says little about underlying inflation pressures. For example, at no point has inflation excluding energy and food exceeded 2 per cent. And stripping out the impact of tax rises and increases in administered prices, inflation has been below 2 per cent throughout.  

The argument for targeting headline (as opposed to core) inflation is that it is the headline rate which sets inflation expectations and wage settlements, and hence the future rate of inflation. But this has not been the case: the headline rate of eurozone inflation fell to 1.2 per cent in April 2013. Excluding energy and food, as well as rises in taxes and administered prices, it will have been just 0.4 per cent and hence perilously close to zero. In some countries this underlying measure of inflation is already well into negative territory. For example, in Spain prices are falling by between 0.5 per cent and 1 per cent. The headline rate of inflation will fall back rapidly, once the impact of tax rises and increases in administered prices fall out of the inflation indices. The reasons for the extreme weakness of underlying inflation are obvious. With economic activity so depressed, workers are having to accept whatever wage rises employers offer, while firms are having to cut prices because disposable income is falling.

Many eurozone policy-makers appear to welcome the fact that inflation is now so low in the struggling eurozone countries. After all, only by ensuring that their costs rise less slowly than Germany’s can they hope to rebuild their trade competitiveness.  But they also need some inflation in order to gradually erode the real value of their debts and ensure their debt burdens are sustainable. Were German inflation running at 3-4 per cent, the struggling eurozone economies might be able to reconcile these conflicting pressures. But German inflation stood at just 1.1 per cent in April, making the adjustment very difficult. 

The European Commission likes to laud the narrowing of current account deficits in the peripheral countries as evidence of the progress these countries are making in boosting their competitiveness.  But this is largely down to collapsing demand for imports, not wage restraint or structural reforms. For example, Spanish imports were 20 per cent lower in 2012 than in 2007, Italy’s fell 12 per cent over the same period. This, in turn reflects the weakness of domestic demand – down by 13 per cent and 9 per cent respectively over this period. Were domestic demand to recover in Spain and Italy, their current account deficits would quickly widen again. As the Commission’s own data illustrate, real exchange rates remain hugely out of kilter across the eurozone. The ‘German euro’ is strongly undervalued, whereas in Italy and Spain the reverse is the case. 

Normally, when faced with such pervasive economic weakness and mounting deflation pressures, central banks would be doing whatever it took to raise inflation expectations. Only in that way can they hope to bring about the negative real interest rates needed to persuade firms and business to invest: when real interest rates are negative, it is expensive to sit on cash. If interest rates were close to zero, this would mean unconventional measures aimed at loosening monetary policy, such as QE, and committing to run a very loose monetary stance for a prolonged period of time. 

The ECB reduced interest rates by 0.25 of a percentage point to 0.5 per cent at its May meeting, but there is little indication that it is planning an aggressive monetary relaxation. The ECB could also launch QE so long as it concentrated its asset purchases on the eurozone assets as a whole rather than on particular member-states. Crucially, it could attempt to boost inflation expectations by committing to keep interest rates at their current lows until 2015 (as the US Federal Reserve has done). At present, the impact of low eurozone interest rates on inflation expectations is limited by the fear that the ECB will tighten as soon as inflation starts to rise. If households and businesses are confident that policy will remain loose even once inflation has started to rise, it could make them readier to spend rather than sit on cash.

There are essentially two reasons why this is not happening. First, Europe’s policy-makers continue to deny that Europe is in a liquidity trap. They believe that eurozone economies are so weak because growth potential has fallen steeply, rather than because demand has fallen far short of supply. The solution therefore lies in structural reforms; monetary stimulus and a drive to raise inflation expectations would achieve little. There is no doubting that the rate of potential output growth across the eurozone has fallen as a result of structural problems. But there is also no doubt that output gaps (the difference between actual and potential output) remain huge, as acknowledged by the IMF, and are getting bigger as households are not spending and firms are not investing. 

Second, although the eurozone as a whole needs higher inflation, some countries are much more in need of it than others. The Bundesbank has acknowledged that higher German inflation could be necessary to facilitate adjustment, but concern that it could erode the real value of savings means that Germany continues to stand in the way of monetary stimulus. Although Jens Weidmann voted in favour of cutting interest rates at the ECB’s meeting earlier this month, he has warned that the eurozone must avoid negative interest rates. 

However, the choice for Germany is not between the status quo or higher inflation but between large debt defaults across the eurozone (and a possible dismantling of the eurozone) on the one hand or higher inflation on the other. The least painful of these would be higher inflation, even if it were unpopular with German savers. Default was manageable in Greece, but defaults by Italy and Spain would pose an incomparably sterner test for the eurozone. The collapse of the euro, even ignoring the political fall-out, would be very painful for Germany: the country’s real exchange rate would rise very strongly.

Faced with such unpalatable alternatives, the new German government (whatever its composition) will probably not stand in the way of the ECB loosening monetary policy further, perhaps by launching QE. But the Germans are almost certain to oppose any ECB commitment to maintain a loose stance until the recovery is underway and inflation is rising, as this would imply robust inflation in Germany. If so, the central bank could struggle to raise inflation expectations. And the eurozone will struggle to escape its liquidity trap.

Simon Tilford is chief economist at the Centre for European Reform.