As inflation rates continue to fall across the Eurozone one might expect Austrian economists to rejoice. After all, inflation reduces our purchasing power and acts as a hidden form of taxation. Failure to control inflation caused some of the greatest social and political disturbances of the twentieth century, and attempts to centrally plan the monetary system are destined to failure. George Selgin’s “Less than Zero” is the seminal account of how deflation can be beneficial, and why central banks should be willing to tolerate it. However it also provides a useful, and highly relevant distinction between “good” and “bad” deflation. The underlying point that needs to be expressed is that not all deflation is ghastly. Indeed the readily available examples of falling prices – such as the Great Depression – are not representative. Allowing a fear of deflation to prevent deflation in any circumstance will commit monetary policy to steady and suboptimally high inflation. The Great Moderation is perhaps the best example of the harm that can be done when we fail to allow increases in productivity to manifest themselves in falling prices. But the relevant point is whether this is the situation we find ourselves in right now.
Austrians tended to be ahead of the expectations revolution therefore to some extent it isn’t inflation or deflation per se that matters, but how it ties into expectations. If the inflation rate is falling, and especially if it’s falling more than expected, we have problems. If inflation is 2% a year, but this is anticipated, then the costs of inflation are reasonably low. If it’s -2% a year, and anticipated, ditto. The problems occur if we transition from one to the other.
Inflation in the Eurozone is currently 0.3%, and the rate has been steadily falling since early 2012. There’s two main reasons why we may expect falling pressure on prices. One is that the underlying capacity of the economy has increased. Positive productivity shocks will increase the potential growth rate, make it easier to produce output for a given amount of inputs, and make things cheaper. In terms of Dynamic AD-AS analysis
, it constitutes an increase in the Solow curve. This is good deflation. But it also implies that real GDP will be rising.
Alternatively, prices might be falling because of a reduction in what Keynesians call “aggregate demand”, Monetarists call “nominal income”, or what Austrians call “the total income stream”. These are all various ways to refer to total spending. This could fall as a result of a monetary contraction, or an increase in the demand for money. It’s important to realise that whilst central banks are the prime culprits of the former, they are also a key instigator of the latter. Keynesians might blame it on “animal spirits”, but we can also think of this as “regime uncertainty”. These are two ways to treat confidence as a meaningful concept, and something that can be negatively affected by central bank policy.
Many commentators attribute low inflation to low oil prices. On the surface this seems like a positive supply shock and hence the reason for low prices is a good one. However the reason oil prices are low is because of increases in supply and decreases in demand. The former is a result of IS getting the keys to the pumps. The latter is due to a slowdown in China. Neither of these bode well for the global economy. Both of them have reduced confidence.
We can see this negative AD shock in the data. With GDP growth of just 0.7% this means that total spending is just 1%. This is significantly lower than where we would like it to be in a world with a greater rate of achievable growth and a 2% inflation target.
So what needs to be done? Austrians are loathe to advocate monetary activism and for good reason. But the goal of monetary policy is not inactivism, but neutrality. The issue comes down to the costs of adjustment. If aggregate demand remains at 1% then people will adjust their expectations, prices will adjust, and output will return to normal. During the Great Depression Hayek advocated this path, even though he recognised that prices take time to adjust, and whilst they do so unemployment would rise. His reasoning was that increasing the load on price adjustments will increase their flexibility. In a time of chronic wage and price inflexibility it was a moment to bust the unions. However he later came round to the idea that those costs were too high. The collateral damage of using a downturn to put more emphasis on nominal wage adjustments was unfair. For the mass unemployed, nominal wage rigidities isn’t their fault. So instead of placing the burden on wage adjustments, central banks have the option of maintaining a certain level of total income. This avoids the necessity of a nominal wage adjustment, in part because inflation allows real wages to adjust.
The fact that we are starting to see inflation expectations fall
implies that this is only the beginning of an economic adjustment. If the total income stream continues to grow at a less than expected (and possibly even a negative) rate then we will have plenty new problems to worry about. This isn’t just the economy responding to the pre 2007 boom. This is the economy responding to fresh problems being introduced by central bank incompetence.
The difficulty for the ECB – and possibly the explanation for why things are so much worse in the Eurozone than in the US or UK – is that they don’t have the same tools available. But let’s leave a debate over tools for another time. The bottom line is that the ECB should be striving to give clear guidance and generate credibility for pursuing a steady increase in a target nominal variable. Monetary policy cannot generate wealth – all it can do is buy time for governments to sort out their competitiveness and improve their public finances. The fact that they aren’t making use of the breathing room provided by central banks is their fault. But monetary policy can destroy wealth, and a failure to maintain a steady total income stream is contributing to those competitiveness and public finance problems. I would love to believe that this impending deflation is the good sort, or that Eurozone labour markets were flexible enough to allow prices to do all the heavy lifting. But I fear that we’re seeing an impending catastrophe, and the ECB needs to take bolder action to prevent making things even worse.