Draghi's definition of eurozone's problems leaves peripheral nations feeling deflated
Published 16/01/2014 | 02:30
Here is some unwelcome news for the likes of Greece, Ireland and Cyprus: apparently it isn't really deflation if you deserve it.
That's the takeaway from remarks by ECB chief Mario Draghi, who despite persistently falling prices in some eurozone peripheral economies, was at pains last week to define the problem away.
"We define deflation as a broad-based self-fulfilling, self-feeding fall in prices," he told a press conference after the ECB left rates on hold. "We don't see that in the euro area. We may see negative inflation rates in one or two countries, but we should also ask the question of 'how much is due to the necessary rebalancing of an economy which lost competitiveness and had gone into financial and budgetary crisis and how much is due to actual true deflation?'"
This strikes me as being an unnecessarily narrow definition, though useful for a man in Mr Draghi's predicament. Not only is eurozone-wide inflation, at just 0.7pc, well below the ECB's target of just under 2pc, but both Spain and Portugal are teetering on the edge of deflation, with yearly inflation increases of, well, nothing.
While it is true that the self-perpetuating effect of deflation -- the tendency to put off to tomorrow what may well be cheaper -- is particularly pernicious, the fact remains that prices are falling in significant areas of the eurozone due to a huge slump in demand and, as Draghi implies, as countries attempt to make themselves competitive without being able to sink their currencies.
This is no benign 19th Century deflation, due to improvements in productivity or the opening of the American grain basket. This is a grinding process under which wages and living standards fall abruptly.
Mr Draghi is right that there are huge differences between Japan in the 1990s and Europe today: corporate and financial sector balance sheets are healthier. Although efforts to reform the banking system in the eurozone are to be praised, it is also true that getting from here to there will involve further deflationary policies.
None of this is to say that Greece, Ireland, Portugal and the rest weren't partly or principally responsible for their downfall. Obviously they were and are. But they are also, patently, suffering through a deflation, a deflation that is self-reinforcing and that current monetary policy is inadequate to remedy.
Perhaps the better way to understand this treatment of deflation is as a tacit acknowledgment of the ECB's untenable position.
Mr Draghi is hemmed in. While he stressed forward guidance, money market rates show that the ability of talk to steer rates near the zero bound is limited. On top of that, there is a rather large de-leveraging going on. Not only are banks repaying debts incurred under the ECB Longer-Term Refinancing Operation, they are shedding assets to prepare for new tougher standards under banking union. That is having, and will have, a further depressing impact on the eurozone, and not just in Ireland or Greece.
Given these realities, and given a real reluctance at the central bank to engage in outright quantitative easing, Draghi's options are limited. His ability to respond to deflation -- for that is what it is -- in weaker eurozone states is perhaps even more limited, both practically and politically.
What Mr Draghi's remarks tell us, then, isn't so much about the real state of the eurozone economy, but about the real limits on his powers. More liquidity provision in coming months is likely, and it is very possible that the ECB lowers benchmark rates, now 25 basis points, even closer to zero.
But it will take more than pain on the fringes to get the ECB to engage in outright quantitative easing. While the ECB is allowed to buy assets in secondary markets, doing so would be extremely divisive, and, to judge by the US experience, might do more for people with large portfolios of financial assets than struggling school teachers in Athens.
For QE in the eurozone to become a reality then, we'd need not just deflation in the places that "deserve" it, but more evidence of emerging deflation elsewhere. For the time being, prices are likely to continue to fall in places like Greece and Cyprus. Call that whatever you like.