Readers Question: Is there an inbuilt deflationary bias in the Eurozone?
Deflationary bias means that there is a tendency for economic policy to promote lower growth and lower inflation. It means there are pressures which keep demand subdued leading to lower inflation, higher unemployment and lower growth.
To a large extent, I agree that there is a deflationary bias in the Eurozone.
Inflation Target
The ECB have very strong attachment to keep inflation less than the target of 2%. For example, in 2011, cost push factors led to an increase in the headline rate. The ECB responded by increasing interest rates. The Bank of England responded by keeping interest rates at 0.5% (even though inflation was much higher in the UK than EU). The Bank of England argued it was important to give importance to wider economic issues of growth and unemployment. The ECB were much less willing to accept, even a temporary deviation from the inflation target over fears temporary inflation would increase inflation expectations. It should the ECB are willing to risk lower growth than risk higher inflation. (see also: ECB v Bank of England)
Internal Devaluation.
Members of the Eurozone have a common currency. Therefore, they cannot devalue the currency if they lose competitiveness. By contrast, in 2007, UK exports were relatively uncompetitive. In the recession of 2008/09, this led to a sharp fall in the value of the pound to restore competitiveness and reduce the UK current account deficit with the Eurozone.
Other Eurozone countries had become relatively uncompetitive (Greece, Spain, Portugal and Ireland) This is reflected in the size of the current account deficits (upto 10% of GDP – which is very high) They cannot devalue the currency. To regain competitiveness, create jobs and reduce current account deficit, they need to reduce inflation. (i.e. reduce wages, and other costs). However, to regain competitiveness may require very substantial reduction in wages and costs. Therefore, this may lead to a prolonged period of low inflation or deflation. This in turn leads to lower growth.
Reducing a current account deficit of 10% of GDP through internal devaluation, does create an inbuilt deflationary bias. If devaluation was an option, they could restore competitiveness quicker with less adverse impact on the rate of growth.
Fiscal Austerity.
Markets have greater fear Eurzone countries will have liquidity shortages (their Central Banks can not buy bonds in case of liquidity shortages). Therefore, many countries are facing pressure to reduce government spending and reduce budget deficits which leads to lower growth.
Monetary Stimulus
The ECB is reluctant to engage in any quantitative easing.
- They are reluctant to create any possibility of future inflation
- The ECB is reluctant to start buying bonds of different countries, deciding which to buy.
The result is that countries with many deflationary pressures (strong exchange rate, fiscal austerity) don’t have any monetary stimulus to offset the fall in demand. (e.g. UK can pursue quantitative easing when we experienced deep recession). Countries in Eurozone can’t.
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