Good and bad deflation – and horribly low euro zone M3 growth

I had an up-ed in today’s edition of the Danish Business daily Børsen. Here is the English translation:

Recently inflation has fallen sharply in most European countries and in some countries we already have deflation, and it is very likely that deflation will spread to several European countries in the near future.

In Sweden inflation has already fallen below zero , as is the case in several southern European countries.

There is certainly reason to fear deflation. In the 1930s deflation was allowed to spiral out of control and the consequences were disastrous. But in this context it is extremely important to remember that there are good and bad deflation.

The overall price level in the economy may fall for two reasons. First, productivity increases may cause prices to fall. As will falling input prices – for example lower oil prices. Second, a general contraction in aggregate demand – for example due to tighter monetary policy – can reduce the price level.

Economists normally call productivity increases and falling oil positive supply shock. They are unilaterally positive as an positive supply shock overall increases prosperity. That’s the good deflation.

Conversely a general decline in prices, which is a result of weak aggregate demand – a negative demand shock – is purely negative as it usually leads to higher unemployment and lower capacity utilization in the economy. That’s the bad deflation.

In general the economic development in Europe in the last five years has been characterized by very weak demand development. It has created ​​clear deflationary trends in several European economies. That certainly has not been good. It has been a bad deflation.

However, the recent decline in European inflation we have seen is primarily a result of falling oil prices – that is a good deflation, which in shouldn’t be a worry. The paradox is that these recent (positive) deflationary trends in the European economy seems to have caused the European Central Bank to wake up and reduce interest rates and it is now being speculated that the ECB will undertake further action to ease monetary policy.

According to the monetary policy textbook central banks should not respond to “good deflation”. This obviously could give reason to question the fact that the ECB is now finally moving to ease monetary policy. But the truth is that the ECB in the past five years have failed to sufficiently aggressively ease monetary policy to to avoid bad deflation.

Therefore, one can rightly say that the ECB is doing the right thing by easing monetary policy, but basically for the wrong reasons. But let’s just be happy that the ECB finally makes the right decision – to ease monetary policy – even if it is not for the right reasons.

The big question is now how the ECB will ease monetary policy when interest rates are already close to zero. But this “problem” is easily solved. A central bank can always ease monetary policy – even when the interest rate is zero. The Federal Reserve and Bank of Japan have solved this problem. They have simply increases the monetary base. The ECB has so far been very reluctant to move in this direction, but the fact that we are now moving toward deflation in the euro zone may also cause the ECB to move forward in this field. Let’s hope so – because if the ECB does not move in this direction we’re going to have ongoing problems with deflation – bad deflation – in Europe very soon.

Today we got more data underlining the fact that the ECB should be seriously worried about bad deflation. Hence, euro zone M3 grew by only 1.4% in October. The Telegraph’s Ambrose Evans-Pritchard has an excellent comment on the horrible M3 numbers:

Eurozone money supply growth plummeted in October and loans to firms contracted at a record rate, heightening the risk of a stalled recovery and Japanese-style deflation next year.

The European Central Bank said M3 money growth fell to 1.4pc from a year earlier, lower than expected and far below the bank’s own 4.5pc target deemed necessary to keep the economy on an even keel.

Monetarists watch the M3 data — covering cash and a broad range of bank accounts — as an early warning signal for the economy a year or so in advance. “This a large dark cloud hanging over the eurozone in 2014; it means the public debt ratios in Southern Europe are at greater risk of exploding,” said Tim Congdon from International Monetary Research.

M3_2749266c

Ambrose also quotes me:

“The ECB needs to cut rates to zero and launch quantitative easing (QE) to head off deflation, but they are not there yet,” said Lars Christensen from Danske Bank. “The debt problem in Italy will be much worse if they let nominal GDP fall, leading to yet more austerity.”

So yes, we are seeing some good deflation in the euro zone at the moment and we should be happy about, but unfortunately we are likely to see a lot more bad deflation soon if the ECB does not get its act together soon.

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Let me say it again – the euro zone is heading for deflation

Ambrose Evans-Pritchard at the Telegraph quotes me on the risk of deflation in the euro zone:

Lars Christensen from Danske Bank said the EU authorities are repeating mistakes made in Japan in the early 1990s when deflation became lodged in the system. “Several eurozone countries are already in outright deflation, and that is making it even harder to deal with banking problems and the debt trajectory. There is no growth in the money supply, so this is going to get worse, not better.

“This is just like Japan. The central bank thought money was easy when in fact it was much too tight. But effects could be much worse in Europe because unemployment is so much higher.”

And yes I said it many times before – just see herehere and here.

End the euro crisis now with a 10% M3 target

This is Michael Steen in the Financial Times:

Inflation in the eurozone dropped unexpectedly to an annual rate of 0.7 per cent in October, far below the European Central Bank’s target of close to but below 2 per cent, and significantly increasing the chances of an interest-rate cut.

The so-called “flash” estimate by Eurostat, the EU’s statistical office, showed that the rate at which prices rise had slowed further since September, when it was 1.1 per cent, which is roughly what economists had expected for October.

A sharp outright fall in energy costs, by 1.7 per cent, drove the slowdown in the harmonised indices of consumer prices, which the ECB targets, but “core inflation”, which strips out energy, food, alcohol and tobacco, also fell to 0.8 per cent from 1 per cent.

I must say I am not the least surprised by the fact that the euro zone is heading for deflation. This is what I told The Telegraph’s Ambrose Evans-Pritchard back in March:

“Europe is heading into a deflationary scenario if they don’t do anything to boost the money supply,” said Lars Christensen… “This already looks very similar to what happened in Japan in 1996 and 1997.”

It is tragic, but what we are seeing now in Europe is exactly the same as we saw in Japan in the mid-1990s – a central bank that pursued extremely tight monetary policies, while it continued to maintain that monetary policy was indeed very easing. We all know the result of the Bank of Japan’s failed policies was 15 years of stagnation and deflation – and sharply rising public debt levels. The ECB unfortunately is copying exactly the policies of the (old) BoJ instead of learning the lesson from the new BoJ’s effective anti-deflationary policies.

As I have earlier argued the development in velocity and money supply growth in Europe today is very similar to what we saw in Japan around 1996-97. Not surprisingly the outcome is the same – extremely weak nominal GDP growth and deflationary tendencies. In fact the outcome is much worse. Unemployment in the euro zone just keep on rising – contrary to the situation in the US, where the Fed’s monetary easing over the past year has helped improve the labour market situation.

In fact the latest unemployment numbers for the euro zone published yesterday (Thursday) shows that unemployment in the euro zone has reached a record-high level of 12.2% in September and even worse youth unemployment is now 24.1%. It is hard not to conclude that the ECB is directly responsible for the millions of European being without a job. Yes, there are serious structural problems in Europe, but the sharp increase in unemployment levels in the euro zone since particularly since the ECB’s misguided rate hikes in 2011 is nearly totally the fault of the ECB’s extremely tight monetary policy stance.

We are heading for deflation

But lets get back to why deflation looks more and more likely in the euro. This is what I had to say about the matter back in March:

If you don’t already realise why I am talking about the risk of deflation then you just have to remember the equation of exchange – MV=PY.

We can rewrite the equation of exchange in growth rates and rearrange it. That gives us the the following model for medium-term inflation:

(1) m + v = p + y

<=>

(1)’ p = m + v – y

If we assume that money-velocity (v) drops by 2.5% y/y (the historical average) and trend real GDP growth is 2% (also more or less the historical average) and use 3% as the present rate of M3 growth then we get the follow ‘forecast’ for euro zone inflation:

(1)’ p = 3 % + -2.5% – 2% = -1.5%

So the message from the equation of exchange is clear – we are closer to 2% deflation than 2% inflation.

Yes, it is really that simple and the policy makers in the ECB should of course have realized this long ago.

End the euro crisis now with a 10% M3 target

There is only one way to avoid deflation in the euro zone and that is an aggressive monetary policy response in the form of a significant and permanent expansion of the euro zone money base within a clearly defined rule-based framework.

I would obviously prefer that the ECB implemented an clear NGDP level targeting rule, but less might do it – and a lot of other policy options would be preferable to the present mess.

The “easy” solution would be for the ECB to re-instate its former two-pillar monetary policy – a money supply (M3) growth target and an inflation target. Therefore, I suggest that the ECB imitiately issues the following statement (I have suggested it before):

“Effective today the ECB will start to undertake monetary operations to ensure that euro zone M3 growth will average 10% every year until the euro zone output gap has been closed. The ECB will allow inflation to temporarily overshoot the normal 2% inflation. The ECB has decided to undertake these measures as a failure to do so would seriously threatens price stability in the euro zone – given the present growth rate of M3 deflation is a substantial risk – and to ensure financial and economic stability in Europe. A failure to fight the deflationary risks would endanger the survival of the euro.

The ECB will from now on every month announce an operational target for the purchase of a GDP weighted basket of euro zone 2-year government bonds. The purpose of the operations will not be to support any single euro zone government, but to ensure a M3 growth rate that is comparable with long-term price stability. The present growth rate of M3 is deflationary and it is therefore of the highest importance that M3 growth is increased significantly until the deflationary risks have been substantially reduced.

The announced measures are completely within the ECB’s mandate and obligations to ensure price stability and financial stability in the euro zone as spelled out in the Maastricht Treaty.”

That would end the euro crisis, while also ensuring inflation around 2% in the medium-term. There would be no bailing out or odd credit policies. Only a clear and rule based policy to ensure nominal stability. How hard can it be?

BIS is fearful of bubbles, but is not always right (remember the gold standard?)

I think there is a bubble in bubble fears. This is particularly the the case for central bankers and institutional monetary institutions.

Here  in the Telegraph:

The two watchdogs launched broadsides against central bank largess last week. The BIS — the forum of central banks — was particularly blunt, seeming to imply that quantitative easing “does not work”.

Critics say this risks undermining the credibility of radical measures when more may yet be needed. They fear central banks could repeat the mistake made in 1937 when the Federal Reserve lost its nerve and tightened too soon, tipping America back into depression.

And here is my response in the same article:

“The BIS and the IMF are deeply misguided and risk doing the world a grave disservice. The biggest threat right now is irrational fear of bubbles among central banks,” said Lars Christensen 

Particularly the advise of BIS is taken to be very important as the general perception is that the BIS “got it right” prior to the crisis – the fact that it got it mostly wrong over the past five year apparently is less important. Paul Krugman has some not too kind words about BIS – or the Sadomonetarists of Basel as Krugman calls the institution headquartered in Switzerland:

I guess we can check the record here and see just how prescient the BIS was. What I do recall, however … is that the BIS has spent years warning about the dangers of low interest rates. Except that a couple of years back it was telling a completely different story about why we needed to raise rates; you see, the big danger was of imminent inflation…

…In fact, inflation is running below target just about everywhere. You might therefore think that the BIS would step back a bit and reconsider both its policy recommendations and the framework it uses to derive those recommendations.

I can, however, do better than Krugman. BIS’ Sadomonetarist tendencies date back more than five years. This is from BIS’ third annual report publish in May 1933:

“For the Bank for International Settlements, the year has been an eventful one, during which, while the volume of its ordinary banking business has necessarily been curtailed by the general falling off of international financial transactions and the continued departure from gold of more and more currencies, culminating in the defection of the American dollar, nevertheless the scope of its general activities has steadily broadened in sound directions. The widening of activities, aside from normal growth in developing new contacts, has been the consequence, primarily, of a year replete with international conferences, and, also, of the rapid extension of chaotic conditions in the international monetary system. In view of all the events which have occurred, the Bank’s Board of Directors determined to define the position of the Bank on the fundamental currency problems facing the world and it unanimously expressed the opinion, after due deliberation, that in the last analysis “the gold standard remains the best available monetary mechanism” and that it is consequently desirable to prepare all the necessary measures for its international reestablishment.”

And this is what I earlier had to say about that report:

Take a look at the report. The whole thing is outrageous – the world is falling apart and it is written very much as it is all business as usual. More and more countries are leaving the the gold standard and there had been massive bank runs across Europe and a number of countries in Europe had defaulted in 1932 (including Greece and Hungary!) Hitler had just become chancellor in Germany.

And then the report state: ”the gold standard remains the best available monetary mechanism”! It makes you wonder how anybody can reach such a conclusion and in hindsight obviously today’s economic historians will say that it was a collective psychosis – central bankers were suffering from some kind of irrational “gold standard mentality” that led them to insanely damaging conclusions, which brought deflation, depression and war to Europe.

Unfortunately BIS’ view haven’t changed much since 1933. Should we listen to the Sadomonetarists in Basel today?

Evans-Pritchard on the Latin Bloc’s “monetarist avenger”

The resident market monetarist at Britain’s Daily Telegraph Ambrose Evans-Pritchard has a comment on European monetary policy under the leadership of the new ECB chief Mario Draghi.

Here is Ambrose:

“Those of a monetarist bent are less alarmed by fiscal contraction (than Keynesians). I have no doubt that monetary stimulus a l’outrance – the classic remedy of Britain’s Ralph Hawtrey, Sweden’s Gustav Cassel and America’s Irving Fisher in the 1930s – can counter the effects of fiscal tightening if conducted in the right way. The debt-to-GDP burden falls faster that way and deflation is averted, a lesson that Japan forgot.

The great question is whether Mario Draghi is embarking on just such a policy, covertly, through his Long-Term Repo Operations (LTRO), starting with €489bn in three-year loans to 523 banks December and to be followed by another blast in February.

The LTRO is not entirely a free lunch. It is replacing funding that has dried up, but to the extent that banks in Italy, Spain, France and Portugal use the cheap money to buy government bonds at rich yields – the Sarkozy “carry trade” – they are not lending to business, as newly bankrupt Spanair can attest…

…Yet, monetarists think Draghi is quietly pulling off a remarkable coup. “This is stealth QE: the impact is dulled because they are not making it clear what they are trying to do, but in the end it may ultimately be as powerful as QE in America and Britain,” said Lars Christensen from Danske Bank.

Tim Congdon from International Monetary Research said Mr Draghi had already boosted total credit to banks from €580bn to €832bn since early November, entirely reversing the Trichet tightening of late 2010.

This may rise to nearer €1.5 trillion this year. While it does not lead to a rise in broad money at first (just the monetary base), it is likely to feed through over coming months in complex secondary effects. “My conclusion is that the Draghi bazooka is such an aggressive example of monetary easing that Eurozone M3 growth will run at 5pc or more [annualized] in mid and late 2012.”

“I (Tim Congdon)remain sceptical about the viability of the European single currency in the long run, but the day of the execution has been postponed once again,” he said.

If Mr Draghi really is the Latin bloc’s monetarist avenger, the Germans will find out soon enough. It is Germany that will overheat, inflate, and suffer a “Latin” credit bubble as EMU’s wheel of fortune turns. Europe’s crisis will take on a whole new political turn. But that is a chapter for tomorrow.”

Needless to say I tend to agree with most things that Ambrose says (and I also find it hard to disagree with Tim). I particularly like that Ambrose mentions Hawtrey, Cassel and Fisher.

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Update: For those interested in my view on fiscal policy see here.

Divisia Money and “A Subjectivist Approach to the Demand for Money”

Recently Scott Sumner have brought up William Barnett’s new book “Getting it Wrong: How Faulty Monetary Statistics Undermine the Fed, the Financial System, and the Economy”. The theme in Barnett’s book is basically that “normal” money supply numbers where subcomponents of the money supply is added up with equal weight give wrong measure of the “real” money supply. Instead Barnett’s recommend using a so-called Divisia Money method of the money supply.

Here is a William Barnett’s discription of divisia money (from the comment section on Scott’s blog):

“Unlike the Fed’s simple-sum monetary aggregates, based on accounting conventions, my Divisia monetary aggregates are based on microeconomic aggregation theory. The accounting distinction between assets and liabilities is irrelevant and is not the same for all economic agents demanding monetary services in the economy. What is relevant is market data not accounting data.”

And here is the official book discription of Barnett’s book:

“Blame for the recent financial crisis and subsequent recession has commonly been assigned to everyone from Wall Street firms to individual homeowners. It has been widely argued that the crisis and recession were caused by “greed” and the failure of mainstream economics. In Getting It Wrong, leading economist William Barnett argues instead that there was too little use of the relevant economics, especially from the literature on economic measurement. Barnett contends that as financial instruments became more complex, the simple-sum monetary aggregation formulas used by central banks, including the U.S. Federal Reserve, became obsolete. Instead, a major increase in public availability of best-practice data was needed. Households, firms, and governments, lacking the requisite information, incorrectly assessed systemic risk and significantly increased their leverage and risk-taking activities. Better financial data, Barnett argues, could have signaled the misperceptions and prevented the erroneous systemic-risk assessments.

When extensive, best-practice information is not available from the central bank, increased regulation can constrain the adverse consequences of ill-informed decisions. Instead, there was deregulation. The result, Barnett argues, was a worst-case toxic mix: increasing complexity of financial instruments, inadequate and poor-quality data, and declining regulation. Following his accessible narrative of the deep causes of the crisis and the long history of private and public errors, Barnett provides technical appendixes, containing the mathematical analysis supporting his arguments.”

Needless to say I have ordered the book at look forward to reading. I am, however, already relatively well-read in the Divisia money literature and I have always intuitively found the Divisia concept interesting and useful and which that more central bank around the world had studied and published Divisia money supply numbers and fundamentally I think Divisia money is a good supplement to studying market data as Market Monetarists recommend. Furthermore, it should be noted that the weight of the different subcomponents in Divisia money is exactly based on market pricing of the return (the transaction service) of different components of the money supply.

My interest in Divisia money goes back more than 20 years (I am getting old…) and is really based on an article by Steven Horwitz from 1990. In the article “A Subjectivist Approach to the Demand for Money” Steve among other thing discusses the concept of “moneyness”. This discussion I think provide a very good background for understanding the concept of Divisia Money. Steve does not discuss Divisia Money in the article, but I fundamentally think he provides a theoretical justification for Divisa Money in his excellent article.

Here is a bit of Steve’s discussion of “moneyness”:

“Hicks argues that money is held because investing in interest-earning assets involves transactions costs ; the act of buying a bond involves sacrificing more real resources than does acquiring money. It is at least possible that the interest return minus the transactions costs could be negative, making money’s zero return preferred.

While this approach is consistent with the observed trade-off between interest rates and the demand for money (see below), it does not offer an explanation of what money does, nor what it provides to its holder, only that other relevant substitutes may be worse choices. By immediately portraying the choice between money and near-moneys as between barrenness and interest, Hicks starts off on the wrong track. When one “objectifies” the returns fro111each choice this way, one is led to both ignore the yield on money held as outlined above and misunderstand the choice between holding financial and non-financial assets. The notion of a subjective yield on money can help to explain better the relationship between money and near-moneys.

One way in which money differs from other goods is that it is much harder to identify any prticular good as money because goods can have aspects of money, yet not be full-blooded moneys. What can be said is that financial assets have degrees of “moneyness” about them, and that different financial assets can be placed along a moneyness continium. Hayek argues that: “it would be more helpful…if “money”were an adjective describing a property which different things could possess to varying degrees. A pure money asset is then defined as the generally accepted medium of exchange. Items which can he used as lnedia of exchange, but are somewhat or very much less accepted are classified as near-moneys.

Nonetheless, money and near-moneys share an important feature Like all other objects of exchange, their desirability is based o n their utility yield. However in the case of near-moneys, that yield is not simply availability. Near-moneys do yield some availability services, but not to the degree of pure money. ‘The explanation is that by definition, near-moneys are not as generally acceptable and therefore cannot he available for all the same contingencies as pure money. For example, as White argues, a passbook savings account is not the same as pure money because, aside from being not directly transferrable (one has to go to the hank and make a withdrawal, unlike a demand deposit), it is not generally acceptable. Even a demand deposit is not quite as available as currency or coin is – some places will not accept checks. These kinds of financial assets have lower availability yields than pure money because they are simply not as marketable.”

If you read Steve’s paper and then have a look at the Divisia numbers – then I am pretty sure that you will think that the concept makes perfect sense.

And now I have written a far too long post – and you should not really have wasted your time on reading my take on this issue as the always insightful Bill Woolsey has a much better discussion of the topic here.

Ambrose Evans-Pritchard once again endorses Market Monetarism

Here is the Daily Telegraph’s Ambrose Evans-Pritchard:

“Central banks have the means to prevent a 1930s outcome, even with rates at zero, if willing to deploy Fisher-Friedman monetary stimulus with conviction, buying assets from non-banks and targeting nominal GDP growth of 5pc. But policy defeatism is in the air, and Austro-liquidationists are winning the popular debate.”

Ambrose continue to be the most outspooken British commentator in favour of NGDP targeting – Market Monetarist style.

See also my earlier post on Ambrose’s views.

 

Wauw! We have a Market Monetarist at the Telegraph

Here is Ambrose Evans-Pritchard at the Daily Telegraph:

“A near universal view has emerged that Europe’s crisis can only be solved by governments and fiscal policy, with varying views over the proper dosage of pain. I beg to differ. This is a monetary crisis, caused by a jejune central bank that aborted a fragile recovery by raising rates earlier this year, allowed the money supply to collapse at vertiginous rates in southern Europe, and caused a completely unnecessary recession — and a deep one judging by the collapse in the PMI new manufacturing orders in November…Needless to say, drastic fiscal austerity is making matters a lot worse. You cannot push two-thirds of the eurozone into synchronized fiscal and monetary contraction without consequences.”

Do I need to say I agree? I do of course – even though I am less worried about the fiscal austerity than Ambrose.

Ambrose continues:

“The eurozone economy is in imminent danger of crashing into deflation, bringing down the whole interlocking edifice of sovereign debt and distressed lenders. And bear in mind that Europe’s bank nexus — including the UK, Swiss, Scandies — is €31 trillion. Big stuff.

This crisis can be stopped very easily by monetary policy, working through the old-fashion Fisher-Hawtrey-Friedman method of open-market operations to expand the quantity of money, ideally to keep nominal GDP growth on an even keel.

We already know that Ambrose is reading the Market Monetarist blogs – now we know he also understands and agrees (I kind of had an idea about that already…did he for example read this comment). Back to Ambrose:

“This does not solve the 30pc intra-EMU currency misalignment between North and South, of course, but it quite literally “solves” the solvency crisis for Italy and Spain. They would not be insolvent if the ECB had not driven them into depression by letting their money supply implode.

Yes, I know there are lots of central bankers who say or think monetary policy cannot achieve these miracles. They are wrong. Of course it can. A whole generation of policy-makers have been side-tracked into cul-de-sacs like (Bernanke) creditism, or German religious theories of “expansionary fiscal contractions”. (By the way, I learned in Ireland last week that the country’s 1980s experience used as the poster child for that credo is based on false data. It does not validate the theory at all).

They have forgotten some basic lessons of economic history. As the Bank of England’s Adam Posen put it, policy defeatism has taken over.

I have no idea whether ECB chief Mario Draghi really believes the mantra he is constrained to utter by his masters. It hardly matters. But his insistence that this crisis must be solved by governments alone — “a new fiscal compact” as he called it today — is a derelection of duty.”

I have nothing to add. Lets just conclude that we have a Market Monetarist at the Daily Telegraph and it is a joy to read his comments.

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If you want to read some of my comments on the topic covered by Ambrose see below.

On “monetary policy defeatism”:
Adam Posen calls for more QE – that’s fine, but…
Gustav Cassel foresaw the Great Depression
“Our Monetary ills Laid to Puritanism”
Calvinist economics – the sin of our times

Fisher (and bit on Friedman):
Repeating a (not so) crazy idea – or if Chuck Norris was ECB chief
The Chuck Norris effect, Swiss lessons and a (not so) crazy idea
Irving Fisher and the New Normal
The Fisher-Friedman-Sumner-Svensson axis

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Update: David Beckworth also has a comment on Ambrose.

 

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