Article published by José Alberto León Alonso in Diario de Avisos on 04/13/2014.
Inflation in the euro zone in the month of March has been reduced to 0.5%, while in Spain the leading CPI indicator places its annual variation at –0.2%. These figures have alarmed economic institutions, considering that Europe and, especially, Spain, is approaching a scenario that includes the economy's worst nightmare: deflation.
The long economic crisis is creating an endless obstacle course. As soon as the panorama begins to clear, a new storm appears on the horizon. The last one is deflation. What does it consist of? In economics, deflation is the generalized and prolonged decline in the price level of goods and services. To be considered prolonged, the price decline must be maintained for at least two consecutive semesters, according to the International Monetary Fund (IMF). Deflation usually responds to a drop in demand and its consequences for the economy are disastrous. But why is a prolonged price drop so negative? After all, consumers would have cheaper goods for our consumption and we would gain purchasing power. Nothing better than an example to show it. Let's assume that prices are reduced every month by no less than half. At first it seems like a joke to the consumer. This month I can buy twice as many goods as last month with the same money. But, if prices will be halved again next month, why not wait a little longer and buy when they are even cheaper? The final result of an expectation of a generalized and prolonged drop in prices is that a good part of consumption and investment decisions are postponed, waiting for new price drops. In a hypothetical situation like the one presented, the economy would collapse due to lack of consumer and investment demand. And how would you get out of this situation? The truth is that there is not much historical background to explain it. Prolonged deflation has only occurred twice in global economic history. The first was in the American Great Depression of the 1930s, and we only got out of it “thanks” to the Second World War, which embarked the States on a level of public spending (and debt) that drove prices up. The second precedent is that of Japan in the early 1990s, when a large real estate-mortgage bubble burst, leading to asset prices collapsing. The country entered deflation and has never emerged from it, no matter how much its political and economic authorities have tried everything. Thus, 25 years later, its stock market is still more than 60% below the values of those years, real estate prices are 70%, its economy stagnant, and its national debt is the largest in the world. Nice panorama.
Is the risk of deflation really that high? The IMF estimates it at 20% in the euro zone, but no less than 60% in Spain. In my opinion, that risk is not that high. The IMF has already been wrong many times in its forecasts, and deflation right now is nothing more than a threat with a reduced probability of occurrence. But it is a real threat that must be monitored. In its latest meeting, the European Central Bank (ECB) affirms that it is prepared to act if necessary, although any measure carries risks that must be carefully evaluated. What could the ECB do to avoid deflation? These are the most obvious possibilities:
Reduce interest rates. The ECB still has room to lower interest rates, which currently stand at the historic low of 0.25%. However, the impact of reducing rates to close to 0% does not seem very relevant and, in fact, the reduction from 0.5% to the current 0.25% last November has hardly had any real impact.
Turn the interest on the deposit facility negative, at 0% since July 2012, which is granted to money deposited by European banks in the ECB. Thus, the capital “saved” by financial entities with the aim of reactivating the circulation of credit would be penalized. I do not believe that it would be an effective measure, since currently there is ten times less money deposited in the ECB than two years ago, in the midst of the financial crisis.
Carry out a new round of banking liquidity (LTRO), although this time conditional on banks providing financing to families and SMEs. The two mega liquidity auctions (LTRO) a year and a half ago granted cheap money to financial institutions and decongested the arteries of the financial sector, but the transmission belt that drives credit from banks to families and companies remains clogged. Despite this, banks are returning the money borrowed at an increasingly faster speed, since they now do not have as many financing problems, so it does not seem that they now have as much “thirst” for liquidity.
It is also not ruled out that the ECB will stop “sterilizing” the bond portfolio it has on its balance sheet after debt purchases. “Sterilize” means that the ECB withdraws from the economy the same amount of money that it uses in bond purchases so as not to generate inflation. This measure is logical, since what is intended now is to generate inflation, not prevent it, but the truth is that the bond markets are so relaxed that the ECB barely intervenes in them and its impact would take time to be noticed.
The last possibility of monetary policy would be to implement an asset purchase program. It would involve printing money through the so-called quantitative easing (QE) by purchasing assets in the markets to boost the economy and inflation. We are not only talking about buying country debt, since that program already exists (the OMT) although it has never been used, but also private assets (that is, loans). The problem is that the purchase of private assets is more complicated in Europe than in the United States, since here we do not have a sufficiently liquid market where these are exchanged, unlike in the United States, since that market broke down when European banks began to distrust each other, and it has never been rebuilt. Additionally, this program would not reach the citizen, but rather the speculators, and would generate bubbles in the stock markets and raw materials markets, and the diversion of that abundant liquidity to other countries, especially emerging ones.
Call me conventional, but none of these options convince me. More than two years ago, I proposed that the European Central Bank print currency and launch the planned plans for the development of energy, transport and telecommunications infrastructure, using the European Investment Bank to do so. The projects to be financed have already been rigorously evaluated, so it would not be a matter of reissuing absurd E plans, airports without passengers or unprofitable AVEs, but of executing projects that generate new business opportunities throughout Europe, including Spain. No financial economy that cannot be seen or touched, but rather necessary material investments that generate economic activity, employment and inflation. One billion euros wisely invested would be enough. If they had done it two years ago, we wouldn't be talking about the threat of deflation now.
