By Desmond Lachman, Resident Fellow, American Enterprise Institute
History is bound to judge harshly the European Central Bank’s recent decision to leave policy interest rates unchanged. For it did so despite the fact that European inflation is now running at less than half of the ECB’s 2 percent inflation target. The ECB also did so despite the fact that European unemployment remains at record high levels and that Europe remains in the grips of a crippling credit crunch that very much clouds its economic recovery prospects.
Among the more troubling developments in the European economy of late has been the precipitous decline in inflation. Excluding volatile items like food and energy, over the past year overall European inflation more than halved from 1.5 percent to 0.7 percent. This takes European inflation to its lowest level in the Euro’s 15 year history, which has to raise the specter that the overall European economy could succumb to deflation.
Equally troubling is the fact that the highly indebted countries in the European economic periphery, like Cyprus, Greece, Ireland, and Portugal, are now either experiencing outright deflation or else are on the cusp of deflation. For deflation will make it very difficult for these countries to dig themselves out from under their very large public and private sector debt burdens.
The deflation risk associated with European inflation falling into what economists generally call the danger zone has not escaped the notice of IMF Managing Director Christine Lagarde. She is now calling on the ECB to be more proactive in its policies to avoid that risk. However, Madame Lagarde’s concerns about a deflation threat are not shared by ECB President Mario Draghi. Indeed, he is stridently dismissive of any notion that Europe might experience anything like Japan’s experience with deflation over the past two decades.
Mr. Draghi’s relaxed attitude towards Europe’s deflation risk is all the more surprising considering the ECB’s own economic forecast. For the ECB itself is forecasting only the weakest of European economic recoveries over the next two years, which will keep European unemployment only marginally below 12 percent by end 2015. And one would think that high unemployment will continue to exert downward pressure on European wages and prices in the immediate future in much the same way as it did over the past year.
In allowing the ECB to fall behind the monetary policy curve by not reacting to Europe’s strong disinflation process, it would seem that Mr. Draghi has forgotten three basic monetary policy lessons that one would have thought that he must have learnt during his doctoral stint at the Massachusetts Institute of Technology. The first lesson, which was famously expounded by Milton Friedman, is that monetary policy operates with long and variable lags. The implication of this lesson is that it is very dangerous for a central bank to allow unemployment to get too high or inflation to get too low. Since, it generally takes a very long time for corrective monetary policy to work its magic.
The second lesson that Mr. Draghi seems to have forgotten is that large gaps in the labor and product markets are generally associated with decelerating price inflation. Had he remembered this lesson, he should not have been surprised when core European price inflation approximately halved over the past year in response to a rise in overall European unemployment to record levels and to the opening up of very large output gaps in countries like Italy and Spain. Had he remembered this lesson, he also would not have been quite as dismissive as he now seems to be about the risks of Japanese-style deflation taking hold in Europe.
The third monetary policy lesson that Mr. Draghi seems to have forgotten is that deflation has a very high cost especially when countries have very high public and private debt levels. For, as Irving Fisher taught us, deflation raises the real burden of any given debt level, which for highly indebted countries heightens the risk of a deflationary trap. One would have hoped that this lesson would not have been lost on Mr. Draghi, especially at a time when a number of countries in the European economic periphery have extraordinarily high public and private debt levels and at the very time when they are already either experiencing deflation or else are on the cusp of deflation.
To put the ECB’s recent decision to leave policy rates unchanged into perspective, it is well to consider how the US Federal Reserve might have reacted under similar circumstances. In September 2012, when the US was faced with a deflation risk, Ben Bernanke’s Federal Reserve responded by setting out on a third-round of quantitative easing that expanded the Fed’s balance sheet by around an additional US$1 trillion over the past year. By contrast, when faced with a similar deflation threat, Mario Draghi’s ECB frets over whether or not it should cut interest rates by a mere 25 basis points. And then the ECB decides to do nothing, which only heightens the likelihood that the ECB is now in the process of repeating the Bank of Japan’s past mistakes.
Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a Deputy Director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.