FOR some time we have worried what would happen if prices started to fall, and now we will find out. In December prices fell 0.2 per cent in the euro area. The European Central Bank – the controllers of the money supply – now have to decide what they will do about it.
ECONOMISTS tend to dislike deflation because of the impact it has on behaviour. Let's say you are planning on buying a new car, but have reason to believe the price will be lower next month. So you keep your old car, and when next month rolls around you realise your old car is still working fine, and the new car might be even cheaper in the future. So you wait.
NOW extrapolate this behaviour across all consumers and companies. Consumption falls. Companies will delay hiring and investing. Moreover, the real value of debt goes up, so there is less incentive to take out loans for major purchases or investments. If the worst happens an economy moves into a deflationary spiral. Falling prices causes lower production, which leads to lower wages and demand, which in turn leads to even lower prices.
HOWEVER, while the 0.2 per cent fall in prices has generated a lot of interest and hand-wringing in the press, it is important to point out that most of this is due to a fall in energy prices thanks to the drop in the price of oil. The core inflation rate – discounting volatile food and energy prices – actually rose 0.7 per cent in December in the euro area. Still, if you have a fire on your stove top you should call the fire department before the whole kitchen goes up.
OUR fire department is the ECB. Their mandate is to keep the inflation rate slightly below 2.0 per cent. They also keep stability in the financial system, like when they intervened in the banking markets during the worst days of the debt crisis.
OTHER central banks such as the Federal Reserve and the Bank of England have used quantitative easing as a tool. They buy longer term government bonds to increase the money supply and push longer term interest rates down. The goal is to increase private sector spending and push inflation higher.
HITHERTO the ECB has avoided quantitative easing. It involves the buying and holding of government bonds, which leads to the monetisation of national debt. This could be considered a redistribution of financial risk: if the Bank of Finland, for example, bought and held Greek bonds, we could be financing their national debt.
YET there are signs that the central bankers are becoming more favourable to the idea. The Swiss central bank unexpectedly abandoned their peg of the Swiss franc to the euro, hinting that something major was afoot. Various finance ministers and central bankers have said they were not opposed to quantitative easing.
I'M IN favour of the idea. The moribund economy is not showing substantial signs of recovery, and national governments are constrained in their expansionary fiscal policies. The ECB has many tools at its disposal, and their reluctance to use them has been one of our biggest problems.
David J. Cord