There seems to be no end to the creative ways by which people justify outrageously contractionary monetary policies. First we were told that monetary stimulus was unacceptable because the ECB needed to focus like a laser on 2% inflation. Now we are told that 2% inflation is unacceptable because the ECB must allow the peripheral countries to experience the wonders of beneficial deflation. I guess I should be happy that people finally recognize that inflation is the wrong target, but I somehow expected something better to replace it. Here’s the Michael Heise in the Financial Times:
Nonetheless, bank lending has been on the retreat, bankruptcies have soared and disposable incomes have fallen. This is the kind of demand shock that fosters bad deflation: a financial crisis causes aggregate demand to shrink faster than supply, resulting in falling prices.
However, looking through the lens of aggregate supply, the difficulties of the eurozone’s periphery bear only a superficial resemblance to those plaguing Japan. In this case, falling prices are the result of a supply shock, through improved productivity or real wage reduction.
Low inflation or even deflation is testament to the fact that (painful) adjustment through structural reforms is finally working.
Actually the situation in the periphery is a lot like Japan, if not worse. After all, Japan does not have 12% to 27% unemployment (even accounting for mismeasurement in Japan.)
When AD declines you see a decline in both output and inflation. Then the self-correcting mechanism takes over. Heise seems to be suggesting that we are now seeing the self-correcting phase. But that’s clearly not the case; if it were then RGDP growth in the periphery would be above trend.
The mistake is to look at the inflation rate, which tells us nothing of interest. Rather the key variable is NGDP, where growth has slowed sharply since 2010, pushing the eurozone into a double-dip recession. That’s a demand shock, pure and simple. If the ECB raises the NGDP growth rate (and there are a few signs it may be shifting toward easier money) then the self-correcting mechanism will kick in. For any given growth rate of NGDP, more deflation is better. But first you need the NGDP growth.
The eurozone periphery is regaining competitiveness via internal devaluation. This could even be called “good deflation”, and is a world away from Japan, which slipped into deflation because it was able to duck structural reforms for too long with the help of expansionary fiscal policies.
So in Japan bad supply-side policies and fiscal stimulus cause deflation? I’m lost; I thought both were inflationary. I’m hoping that commenters can help me here, because this also seems crazy:
In the eurozone, both reasons for deflation – good and bad – interact. On the one hand, low inflation or deflation is a welcome reaction to structural reforms as they accelerate the restoration of (cost) competitiveness; on the other, it is a troubling sign of economic depression as it aggravates the problem of excessive debt.
It is not at all clear whether the ECB’s response addresses the good or bad sort of deflation. The ECB could easily end up killing the wrong guy.
So now it’s not clear whether easy money boosts AD or reduces AS? Really?
I’m all for wacky unconventional theories, this blog is full of statements that seem crazy to others. But I never insult the intelligence of my readers. I assume all my readers know the basic AS/AD model, and I assume that the FT’s readers also understand that model. It’s fine if you want to say things that seem totally strange on the surface, but if you do so then please provide us with an explanation. I always do so, and expect no less from the world’s leading financial newspaper.
PS. Everything in this post is doubly true when you considered that Heise’s article is saturated with the language of AS/AD, so he certainly can’t claim those concepts are irrelevant to his analysis.
PPS. Ryan Avent has a much better piece, which ends up by pointing to the similarities between inflation targeting and the gold standard:
The belief in the critical importance of low and stable inflation is more flexible than the gold standard was, and it is born of a better understanding of the workings of the macroeconomy. But it is a binding constraint on recovery and prosperity all the same. And the unwillingness to question its continued utility in the face of evidence that it is doing real harm looks all too similar to the intellectual fetters that led central bankers to persist in foolish policy in the early 1930s.
Pegging the price of gold failed to stabilize US national income, which fell in half from 1929 to early 1933. Targeting inflation failed to stabilize US national income, which fell 4% between 2008:2 and 2009:2. If we want to stabilize national income, why not target national income?
Ryan mentions a higher inflation target, but that’s not needed. The reason so many Keynesians keep returning to that assumption is that they rely on the wrong model, IS/LM with a downward-sloping IS curve. If they could somehow absorb Nick Rowe’s insight that the IS curve is often upward-sloping (especially for large monetary policy shifts), then they’d realize that NGDPLT is enough, no need for a higher inflation target. Easy money creates faster NGDP growth, which raises nominal interest rates. The zero bound is not a factor preventing monetary stimulus, it’s the result of an excessively low (implicit) NGDP target.
HT: Nicolas Goetzmann