Wolfgang is right – bold action needed in the euro zone to avoid deflation

Wolfgang Münchau has a good up-ed on the risk of deflation in the euro zone, while I do not agree with everything Wolfgang says I think he is 100% right about the significant risk of deflation in the euro zone and that bold policy action is urgently needed to curb deflationary pressures in the euro zone.

I particularly find this paragraph interesting:

Remember what happened in Japan? Once its economy settled to a new steady state with negative inflation and zero growth rates during the 1990s, it got stuck in a hole. There is still a dispute over whether fiscal or monetary policy is the more suitable instrument in such a situation. But there is no dispute that a policy mixture that consists of fiscal rigour, excessive monetary tightness and a refusal to deal with the zombie banks is not going to work. The ECB always says Europe is not Japan. Indeed, it is not. Europe’s position is potentially worse.
Wolfgang is right – we are in Europe now copying the policies of Bank of Japan, which led to more than a decade of deflation and consistently rising debt problems. See here about what I have earlier said about Europe copying Japan.
Wolfgang calls for the ECB the to ease monetary policy:
The only tools strong enough to stem deflation are unconventional. These could include purchases of sovereign and corporate bonds, bank bonds or even company shares. They could also include funding-for-lending schemes, support for small company loan securitisations or, in extremis, direct lending to companies. But the longer one waits and the longer deflation festers – the more it affects wage settlements and prices for goods and services – the harder and more costly it will be to get rid of.
What we need is large scale quantitative easing in the EU. Wolfgang – like most other commentators – calls this unconventional monetary policy. However, there is no unconversional about the central bank controling the money base (see here for more on that topic). That is what central banks do. Furthermore, we don’t need more odd credit policies such as funding-for-lending schemes. What we need is a firm commitment from the ECB to ensure nominal stability by increasing the money base so much as to curb deflationary pressures.
I would obviously prefer an NGDP level target for the euro zone, but alternatively I have earlier suggested that the ECB brings back the old second pillar – the monetary pillar – and announce a explicit 10% M3 growth target until the euro zone output gap is closed. That would ensure that we will not fall into a Japanese style debt-deflation trap in Europe.
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  1. Spot on. I was very alarmed to hear a former ECB official tell me that Europe has similar structural features to Japan (demographics & debt). Also puzzled when he told me that QE was not politically possible but credit policies such as buying SME loans or ABS from banks was doable.

  2. If the ECB sees things as described in the op-ed, that is a reason to worry. M3 has been crawling for months now, while credit counterparts are falling. You can’t call that “technical”!

    Ravi, that is very interesting about QE. When I read the position of German const. court on the OMTs, I interpreted it as a very favorable to policy of buying the government debt Lars advocated. They (BVG) were worried that the selectiveness represents an “economic policy” which is not in ECB mandate (price st. & support for general policies), and that the OMTs would disturb price setting in bond markets trough several channels.

    My point is that GDP weighted purchases would just deflate general risk created by ECBs monetary incompetence, but wouldn’t distort relative prices. Buying SME loans and ABS would constitute an “economic policy” since it uses the same formula as OMT-s – focus on one sector of the economy. It would also distort prices. I guess it could fail on BVG, but since there are less political connotations, as you mentioned, these operations wouldn’t be questioned.

    Im not a lawyer + Im good in German, but not for the legal stuff :D, and that is how I interpreted it, love to hear what you guys think!


  3. I find it amazing when central bankers offer structural reasons for deflation and low nominal growth. Any tinpot third-world dictator knows how to create inflation and nominal growth: run big deficits and monetize them. If Mugabe or Chavez can do it, so can Europe.


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