Deflation in Europe: Probable Solutions

Many are concerned about deflation. Acute deflation, as seen in the early 1930s, is cataclysmic; mild deflation, as we see in Japan today, could become self-sustaining. There are, also, parallels between Japan of early 1990s and sections of Europe today: low stock prices, banks under stress and dwindling consumer confidence. It is appropriate to be anxious. However, faith in governments and central banks should alleviate the anxiety of the Europeans, since declining production of goods and services along with decreasing prices is virtually the only problem in economics with a clear way out. Diminishing production with price increase throws up thorny policy alternatives. On the contrary, to price and output declines, there is just one suitable reaction: spurring demand through fiscal and monetary policies. A central bank that is controlled by the government can always kindle nominal demand. Many pundits claim that Japan cannot employ fiscal stimulation to increase demand since the Japanese consumer is more apprehensive of additional public debt, rather than being stimulated by the tax cutbacks or spending growth. But that is basically incorrect. If Japan wished, it could reduce levies and hike its fiscal deficit and could finance that shortfall with non-refundable, interest-free "grants" from the Bank of Japan, that would generate no future liability on the taxpayers and should not matter in metrics of public debt. But that would be very irregular. It would make it plain that governments are able to print money, indefinitely if they choose to do so, a fact carefully camouflaged by standard deals in which governments finance their deficits with interest-bearing securities. Central banks can acquire them in the open market in order that at the combined government-cum-central bank level, no interest liability exists. However, when they do so, that piece of information is not made obvious. Theoretically, the aggressive acquisition of government liabilities by the central bank should still combat deflation. However, once deflation has taken hold, the risk is that this opaque intervention is less potent - being less clear to common consumers and taxpayers - than activist tactics. Japan should now mull over alternative plans, such as direct subsidisation of tax cuts by the Bank of Japan, and/or fundamental reorganization and re-capitalisation of its banks using central bankgenerated currency. Also, ridiculous statements that neither fiscal nor monetary stimulation is possible should not be allowed to run down consumer confidence. The sole restrictions on the capacity of a government and central bank to collectively increase the nominal demand are those shaped by the relationship between the central bank and the government that are outlined by the government itself. However, if possible, Europe should stay away from unusual approaches. This is because the principles of central bank autonomy, and of opaque money creation, have their foundation on understandable suspicions that governments will exploit direct power on the operation of the mints. The ultimate policy blends central bank freedom with means to make sure that deflation never establishes itself and that irregular methods are never necessary. The rationale for clear, positive and symmetric inflation objective, like the Bank of England's 1.53.5 per cent scale, is thus strengthened by the present danger of deflation. If the Bank of Japan had followed such a goal during the 1990s, Japan would not need now to think about irregular tactics. Within the monetary union, two particular features make the argument for a clear inflation objective even more convincing. Firstly, room for manoeuvre with respect to the fiscal policy is very small. Quite a few European countries came into the eurozone with a wobbly fiscal situation,

a build up of too much debt and a current account deficit even in economic upturns. Consequently, they cannot use fiscal stimulus to play its suitable steadying role now by increasing deficits in a downturn as tax income falls and social expenditure rises. Without that freedom, monetary policy becomes the primary deflation-fighting tool. Secondly, if deflation did rear its head, the amalgamation of twelve governments and one central bank would make concurrence on unusual escape means more difficult. Deflation could be even trickier to stamp out than in Japan. Hence, Europe needs credible barricades against it. Of course, the ECB may well work at its own unspoken inflation goal. However, without a known target, an unmanageable communications brief, with consequences for market expectations and its authority, faces it. Consumers and industry ought to know that inflation will be slightly positive; implicit goals deduced from central bank behaviour cannot offer that assurance. Also, if in the future, inflation is again excessive, not too little, the electorate must comprehend that the ECB is increasing interest rates to meet a ceiling inflation rate supported by their government, not for logic known only to the central bankers in Frankfurt. National central banks with a good background can get authority and direct outlooks without unambiguous targets. A new central bank in a continent without a unified single government cant. To reap the benefits of the monetary unification while steering clear of deflationary hazards, the eurozone wants a definite, positive and symmetric inflation goal.

Aayamtathaghat Banerjee