Deflation and the ECB

By Frances Coppola

The ECB continues to argue that there is no deflation risk in the Eurozone though many people dispute this. Headline CPI has been steady at 0.8% for the last three months, and core inflation (which excludes volatile things such as energy prices, which have been falling) is inching upwards. And January’s M3 lending figures for the Eurozone as a whole, though horrible, do show a slight improvement over December.

But as is often the case, looking at Eurozone aggregates doesn’t tell the full story. These charts from Natixis show the collapse of bank lending not only in periphery countries, but in Germany:

(h/t @okonomia)

In an economy where the money supply depends principally upon bank lending, a credit crunch will become deflation unless the money supply is expanded by other means. For the last year, the ECB has allowed monetary conditions to tighten as banks repaid LTROs. It has justified its inaction on the grounds that the credit crunch (and associated deflation risk) only applies in periphery countries, and is a recognition by banks of higher sovereign risk in those countries. Structural reforms, therefore, should over time reduce the sovereign risk, allowing real interest rates to fall and enabling banks to lend. But these charts show that lending is stagnant in Germany and France as well as the troubled Spain and Italy. Evidently, the credit crunch does not apply only in periphery countries.

The right-hand chart – lending to companies – is particularly worrying. Business lending is flat in both Germany and France, the Eurozone’s two biggest economies, and in Spain and Italy it is falling fast. If this were the United States we might argue that falling bank lending to businesses is not terribly informative in the absence of information on capital markets performance. But this is the Eurozone, where the majority of businesses obtain finance from banks, not from capital markets. That level of contraction in business lending is potentially disastrous.

The ECB’s inaction appears to be primarily due to positive growth rates for household credit, particularly in Germany and France: as Draghi says, “households are not deferring purchases”. But it really isn’t good enough to argue that household credit is holding up, and therefore there isn’t a problem. Yes there is. Stagnant or falling bank lending to businesses means stagnant or falling business investment. And that will follow through in due course into higher unemployment, lower wages and depressed demand.

Relying on household credit growth when business investment is stagnant or falling is unwise (UK government, please take note). It is possible that increasing consumer demand could stimulate business investment. But the ECB’s monetary developments report for January suggests that the household credit growth is in mortgages, not consumer lending. I suppose that wealth effects from increased home ownership could encourage higher spending, stimulating business investment. But haven’t we played this scene before, with less than happy results? 

Admittedly, both Germany and Spain show business investment becoming “less negative”, as the ECB puts it. It may be that the slight upturn in German business investment and the larger improvement in Spanish business investment will continue. But in the case of Spain this is from a VERY low base. Remember that these charts show the rate of growth of lending, so a negative means that lending is falling. Spanish business lending is currently falling at a rate of 12% per year. Even if the current improvement continues at the rate shown in the chart, it will be literally years before business investment actually starts to increase. Spain’s unemployment is already at 27%: if it takes years for business investment to start increasing, where will unemployment be? Or will all the young and skilled have left by then?

So the ECB’s remaining excuses for inaction seem to be an increase in consumer credit that is likely to fizzle out unless business investment responds, and a – possibly unjustified – expectation of rising business investment in the Eurozone’s largest economies. This is frankly insufficient. There is a very strong argument for ECB to do something significant to ease monetary conditions. As Tony Yates says, you don’t wait for deflation actually to appear before you take action to prevent it. Whether that action takes the form of QE, negative deposit rates, specific measures targeting bank lending, or Tony’s suggestion of “lower for longer” forward guidance, is a question for ECB officials. But there is serious risk of deflation. The ECB’s continued inaction is dangerously close to incompetence.

The trouble is that any action the ECB takes is fraught with problems. It is so fenced around with treaty limitations and hard-money ideology that it is difficult for it to do anything very constructive without facing political and even legal challenge. In my last post I argued for unwinding of the Euro. That is still my position. But the Euro is what we currently have, and deflation is what we currently risk. The ECB must act, and politicians in the Eurozone must allow it to do so. Treaties be damned.

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