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Home Publications Blogs Beat the Press Andrew Sentance Wants Us to Stop Worrying About Deflation

Andrew Sentance Wants Us to Stop Worrying About Deflation

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Thursday, 29 May 2014 13:54

Andrew Sentance, a former member of Bank of England's Monetary Policy Committee, wrote in the Financial Times that we should stop worrying about deflation. He actually is at least partly right.

Sentance distinguishes between what he calls "chronic" deflation, "benign" deflation, and "price adjustment." He says that we need only worry about the former, a process whereby price declines become self-perpetuating, much as an inflationary spiral can become self-perpetuating. He writes that in this situation people may put off purchases and the real value of debt increases, both of which reduce demand and therefore put further downward pressure on prices. 

Sentance argues that we have little basis for fearing this sort of deflation. He is right. We have not seen this sort of deflationary cycle in any wealthy country since the Great Depression. Even in Japan the periods of deflation were relatively brief, with the rate of price decline almost always less in absolute terms than -1.0 percent.

However it does not follow from this fact that a low rate of inflation is not a problem. The low rates of inflation across Europe mean that real interest rates are much higher than would be desired in a weak economy. Given the high unemployment rate across the euro-zone, a standard Taylor rule would imply a negative real interest rate on the overnight rate of at least -3.0 percent. However with an inflation rate of just 0.7 percent, the European Central Bank can only get the rate down to -0.7 percent with standard monetary policy.

The debt burdens on homeowners and governments are also much greater than would be the case if inflation was eroding the real value of debt at the rate of 2.0 percent a year, or even better at a 3.0 percent or 4.0 percent annual rate. Since most of the outstanding debt was contracted when the inflation rate was higher and expected to remain higher, the lower than expected rates of inflation that countries are now experiencing amounts to a windfall transfer from debtors to creditors. 

More rapid inflation would also facilitate the price adjustment process that is necessary to restore balance within the euro zone precisely because we are unlikely to see the sort of deflationary spiral that Sentance dismisses. The new zero inflation rate in Germany and other core countries means that the peripheral countries can only adjust very slowly with modest rates of deflation. If the core countries had inflation rates of 4.0-5.0 percent, the adjustment could be much quicker.

And Europe is paying an enormous price for this slow adjustment. According to the I.M.F. every country in the euro zone is operating well below its potential GDP with the exception of Malta. In Greece the output gap is almost 10 percent, but the I.M.F. calculates that even core countries like Austria and the Netherlands have output gaps. In these cases, the estimated gaps are 0.9 and 4.7 percent, respectively.

Furthermore, these gaps are measured against sharply lowered estimates of potential GDP. If the I.M.F.'s pre-crisis projections are used as the basis for calculating potential GDP then almost every country in the euro zone would be looking at an output gap of more than 10 percent of GDP. (By comparison, we are supposed to believe that the Transatlantic Trade and Investment Pact, which is projected to raise GDP by 0.5 percent by 2027, is a big deal.)

This suggests that all is seriously not well in the euro zone and that a higher rate of inflation could be an important part of the cure.

 

Comments (3)Add Comment
erroding debt is two sided....
written by pete, May 29, 2014 4:22
While clearly real wage adjustment (downward) would benefit from an inflation in the Euro, the debt argument is problematic. Since debt is zero-sum for the economy, unexpected inflation results in a transfer from lenders to borrowers. Last time I looked, the banks weren't doing too well already. The real issue is that using inflation as a policy tool this way is pretty much untried, and thus frought with danger. Currently central banks have inflation as a target, not a tool.
Last time I checked
written by ifthethunderdontgetya™³²®©, May 29, 2014 9:12
pete, the banks were doing much better than most of the people.

And that's wrong, since the banks blew up the economy to begin with.
~
To put the issue most simply:
written by Denis Drew, May 30, 2014 9:03
To put the issue most simply:

The Fed (and the present administration, too, going by its inaction) seems to worry a helluva lot more about one percent of INFLATION than about one percent of UNEMPLOYMENT.

When you compare the hurtful human consequences of each: who gives a damn about inflation?!

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.

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