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Tuesday, February 24, 2015

EuroGroup - Money For Nothing And Your Debt For Free?

There's an interesting question about "analysis" which confronts anyone who seriously wants to engage in it: do you organize your focus around what you want to happen (practical policy emphasis) or do you concentrate your efforts in detailing and outlining what you think will happen? Naturally the closer you are to having an ideological discourse the harder this distinction is to either see or maintain. But even for "non ideological" thinking the issue is far from being an easy one. Whether or not there is any such thing as "objectivity" is a complex philosophical question and attempts to achieve it fraught with all manner of difficulty, but surely we at least have to try?

I raise this point, because while those who write what is called "sell side" analysis do no more (and no less) than the name suggests - no one would really think such work was either objective or independent - we shouldn't abandon too easily the objective as being unattainable.

The issue becomes even more complex when you consider just how major multilateral institutions like the EU Commission and the IMF have steadily shifted their role since the start of the financial crisis, away from independent criticism and towards "talking up" troubled economies who are under their guidance. I think Larry Summers presented this issue nicely in his IMF research conference speech when he said:
"I agree with the vast majority of what has just been said [by Ben Bernanke, Stan Fischer and Ken Rogoff] – the importance of moving rapidly; the importance of providing liquidity decisively; the importance of not allowing financial problems to languish; the importance of erecting sound and comprehensive frameworks to prevent future crises. Were I a member of the official sector, I would discourse at some length on each of those themes in a sound way, or in what I would hope would be a sound way. But, I’m not part of the official sector, so I’m not going to talk about any of that."
Ever since Robert Lucas shifted attention in economic theory towards the role played by expectations, the artist has somehow been painted into the very picture he or she is painting. You can't talk about a topic without in some way changing the understanding (expectations about) the phenomenon in question. If you write, for example, that the Euro Area is stuck in deflation, doesn't that somehow add to the expectation that it may be?

 But there is another issue, and it's not simply about objectivity or bias, it's about communication, and about what others are prepared (or able) to think about (contemplate) at any particular point in time. I had my own personal problem with this just last week, when I wrote a lengthy post on the so called "good deflation" phenomenon in Spain. I personally think - for reasons which will emerge below - that contemporary deflation is substantially different from the depression-related deflation we saw in the United States in the 1930's, the phenomenon around which much of modern economic theory on the topic cut its teeth. There is a very big difference between a 1% fall in prices every year for 15 years (the Japan experience) and a 15% fall in one year. Modern deflation seems more related to a structural weakness in domestic demand and investment associated with shifting demographic dynamics than it is to ongoing debt deflation, although many would be inclined to deny this.

But is the tendency towards denial based on intensive empirical study of the modern deflation phenomenon, or is it driven by the fact that if the problem is largely demographic then it has no evident solution. This is how the need to do policy can frame analysis, since the objective (sound policy) governs the analysis, indirectly  making the practitioner more inclined toward one hypothesis rather than another.

I personally hold the opinion that modern deflation largely has demographic roots, and basically think policy should come to be about learning to live it, and about how to manage our economies in such a context, rather than continually attempting to escape (Abenomics) from a phenomenon from which there is - in all probability - no escape. That is the approach which characterizes my work on Japan.

But in Spain the debate is at a different point. Whereas in Japan there is a live and ongoing discussion about whether the country should be doing Abenomics or not,  the majority of policymakers and sell-side people in Spain have not reached this point. They are still essentially arguing either that i) the country isn't in deflation, or ii) even if it is, Spain's deflation is of the "good" kind. As a result I ended up writing a piece which argues that Spain is in deflation (and has been for longer than most people imagine) and which explains that - as Tobias Buck described it in his tweet on the piece - "There is nothing good about deflation in Spain".

But if there's nothing "good" about the phenomenon, you might imagine I was suggesting doing something about it, like implementing QE at the ECB, for example. Well basically, if you thought that you would be wrong. I think there is nothing good about Spain's deflation, but that this is what there is. Not a perfect world, and it isn't my objective at this point to go into why people so often seem to imagine it could be. But naturally, if something is "bad" then from a policy perspective you should be looking for a solution, and the solution that's up and coming on the current agenda would be ECB QE. And if you think certain kinds of policy outcomes are likely then it becomes interesting to ask what the world will look like if the policy is implemented, even if you personally don't believe in its efficacy in terms of declared objectives, and this is what I am trying to do in this post.

What I want to look at are the implications of having ongoing deflation and increasing QE at the ECB (both of these contingent but empirically verifiable conditions) for the balance of calculation about whether or not a given country is better off staying in the Eurozone or leaving it. In other words, its a kind of thought experiment based on plausible assumptions: that deflation is demographically driven and that the ECB will continue to implement QE (or QQE) in a (forlorn) attempt to bring it to a halt. I think this kind of line of thought is worth pursuing since it will give us some idea of the kind of world we may be living in 10 years hence and move us on a bit from scrutinizing every piece of communication to determine whether the list of reforms proposed by the Greek government will be acceptable to the German one. Or whether the Greek government will have to meet its short term financing needs by issuing T-bills, or will the ECB will agree to advance the 1.9 billion Euros interest rebate which is pending? Sometimes we need to look beyond the end of our noses.

What Greece Needs Is It's Own Currency?

Judging by what runs through my Twitter feed,  I can't help getting the impression that most London based investors still have a line on debt, currencies and interest rate policy which hasn't evolved that much since the 1990s. The over-riding assumption is the Euro is overvalued for Greece's needs, that having your own currency and being able to implement your "own" monetary policy carry strong benefits, ones which far outweigh - for example - losing the anchor which is provided by an EU promoted structural reforms programme.

That the Euro was set up with major - almost fatal - institutional deficiencies is obvious, possibly now to everyone. Ditto for the fact that for many of the countries who participated in the experiment the balance of the first decade is in all  probability negative. Ditto that the single size monetary policy was manifestly applied counter to the interests of a number of economies on the periphery, economies which subsequently got into a great deal of difficulty.

But the question that really is crying out to be asked is: "has anything relevant changed"? Is there no difference between the world of 1995 and that of 2015? I personally think there is, and that the changes that have occurred can alter how we think about the whole question of Euro Area membership. Possibly to the extent of being able to understand why it is very much not in the interest of the Greeks to exit the currency at this point.

There are a number of features of our current economic and financial environment which make the world a very different place now to the one we used to live in back in the 1990s. These would be:  i) the rise of financial globalization, ii) the arrival of deflation in a number of developed economies and iii) the limitations placed on standard interest rate policy by the existence of the Zero Bound and the rise of non-standard measures, in particular QE.

There is a fourth and separate point - the existence of accumulated sunk costs - which also enter into any calculation about the difference between deciding to join and deciding to leave, but this one has been widely covered in earlier debates about Grexit, so can be treated to some extent as "shared knowledge".

QE at the ECB

January's decision by the Governing Council of the ECB to initiate a series of sovereign bond purchases as part of more general programme of quantitative easing, is historic and its significance goes well beyond immediate deflation concerns. The modality of the programme is more or less as follows:

i) there will be 50 billion Euros in sovereign purchases every month from March 2015 to September 2016 plus 10 billion Euros more under the existing asset backed securities and covered bond programme.
ii) purchases will be from the secondary not primary market (something the European Court of Justice opinion highlighted as important in any ECB programme).
iii) 12% of the 50 billion Euro monthly purchases will be of EU and EU institution securities.
iv) the purchasing will be done by the national central banks and will be in proportion to the capital key share of each country.
v) only 20% of the additional asset purchases will be subject to risk sharing.

This is a large programme, which will produce an increase of around a trillion Euros in the ECB balance sheet. The decision to warehouse 80% of the additional purchases at the national central banks has attracted a lot of attention, since it is clear that this procedure falls well short of full financial integration. The other side of the coin, though, is that it makes the cost of leaving the Euro much higher, since the part of the debt which will be held at the national central bank will effectively be virtually interest free as long as the country is in the Eurosystem (see below) whilst outside the Eurosystem framework such a programme would almost certainly be impossible to implement, and market based  interest rates would be above current ones.

If you are a country with no debt, then maybe life outside the Euro would be beneficial (maybe, there are other considerations), but if you have legacy debts (even restructured ones) then in the context of evolving QE (and there is a long, long way that the ECB can go with this over time) it can only be more expensive for you to find yourself outside. This is so whether you are looking at things from a purely debt sustainability point of view, or from an indebtedness as a drag on growth one. What makes the difference? The arrival of deflation is what makes the difference, since it is this that enables a central bank with deep pockets to increase its balance sheet almost indefinitely with generating inflation. And it is this deflation aspect which makes ECB QE so different from that practiced in the UK or the US, and so similar to what is going on in Japan.

Long Term Disinflationary Trend

Many argue that the current deflation in Europe is simply the result of a short term energy price shock, but as this chart presented by Larry Summers illustrates in support of his secular stagnation hypothesis  illustrates the trend towards negative rates has been a long lasting one.

As has the trend towards lower (and eventually negative) government bond yields.

And inflation in many developed countries has been on a secular downward trend running across decades, as this Swiss CPI chart shows.

So something is happening, and that something evidently isn't simply transitory and energy related. Here's Spanish consumer inflation with the energy component stripped out.

And here's a constant tax (ie without impact of consumer tax hikes) consumer inflation without energy chart.

It should be clear from an examination of these charts that there is a strong underlying deflationary trend in Spain (and by implication in the other economies on the southern periphery). This deflation is the result of weak consumer demand, and the impact of this on investment. In addition, this "deflationary moment" coincides with the turning point in working age population dynamics, entailing the possibility that we will see long term deflation, Japanese style. (For more on Spanish deflation see this post).

If we are seeing the arrival of long term structural deflation, and with it a process know as secular stagnation (Larry Summer's hypothesis), then the policy of Quantitative Easing recently adopted by the ECB will not be short term in duration, nor will interest rates in Europe move far in the foreseeable future from what has become known as the Zero Bound.

Certainly the bank of Japan has not been shy in increasing it's balance sheet.

Yet despite the extensive and ample use of QE and a 40% devaluation in the yen against the US dollar, ex-tax inflation in Japan has been steadily falling back and in December it was down to an annual 0.5%. So obvious is the failure of the policy to really produce sustainable inflation that Shizo Abe policy adviser Koichi Hamada recently argued that the government could cut the inflation target in half (from 2% to 1%) without any major loss of credibility.

So it is far from clear that the ECB's attempts to obtain its price stability target of near to 2% inflation will be successful, although the view you take on the issue will depend on what you think the underlying reason for the deflation really is. This inflation quandary is important since meeting its price stability objective is Mario Draghi's principal justification for introducing sovereign bond purchases under quantitative easing. Indeed Mr Draghi has even stated that far from such purchases not being within the banks mandate, not conducting such purchases (or similar policies) would be illegal under the mandate given its price stability objective.

So, since QE has been introduced until at least September 2016 the possibility exists that it will be continued beyond that point. Indeed it's hard to see how it won't be. And this difficulty in terminating QE will not only relate to inflation insufficiency, debt sustainability will also form part of the picture. Let's take an example.

QE and the French Deficit

The ECB has announced that 50 billion Euros in government bond purchases will be conducted monthly between March 2015 and September 2016. That means a total of around 900 billion Euros. Of these purchases 12% - ie around 100 billion Euros worth - will be purchases of EU institution instruments (not national government ones). So total sovereign bond purchases will be around 800 billion Euros. These will be bought by ECB (or national central banks) in proportion to Euro Area GDP shares.

Now France accounts for around 20% of EA GDP. So we should expect about 160 billion Euros in French bond purchases during 2015/2016. At the same time, the French government deficit is around 4% of French GDP, or an annual 90 billion Euros a year. The conclusion is that the vast majority of this new deficit will be effectively bought by the ECB. Not only that, this debt will be essentially free of interest service charges, since under the seigniorage principal, the French government will recover the interest paid to the ECB (or the national central bank). Obviously this is what I call "money for nothing and your debt for free".

So far, so good. The ECJ gave the opinion that this didn't amount to debt monetization as long as the purchases clearly took place in the secondary market. But let's think about the longer term implications.

Once You Are In QE How the Hell Do You Get Out?

As is widely know, Japanese gross government debt currently constitutes around 245% of Japan GDP. About 30% of that (or 80% of Japan GDPs worth) is now in the hands of the Bank of Japan. This - as explained above - now effectively costs the Japanese government nothing more than the admin costs of handling so many bonds. The proportion of GDP the BoJ stock of bonds constitutes is rising by the month. The other part of the debt (in private hands) costs, thanks to Japanese QQE, very little to maintain as yields have been driven to a very low level (0.4% on 10 year at the time of writing).

Now let's imagine that at some point the Bank of Japan ends QQE. (This again is what is normally called a thought experiment, since if I am right  it simply won't happen). In the first place Japanese bond yields would start to rise on new debt issuance sold to the private sector, while the part of the debt which is "for free" would become less and less as BoJ holdings steadily mature. The debt, remember is very large. This move would constitute an ongoing fiscal tightening (over several years) since interest service debt costs rising would mean less revenue available for government spending, or less demand in the economy. This tightening would almost certainly provoke a relapse of the fragile Japanese economy and most likely induce a return to deflation (if, that is, Japan  had ever really managed to leave).

It seems clear to me at least that Japan can now never completely exit some form of QE, at least it can't do so without going through a major restructuring of its sovereign debt, and a major shake up in its financial system.

Going's On Behind The Veil Of Financial Ignorance

Now lets turn to Europe, and Greece: the country with the second highest gross sovereign debt level globally (175% of GDP). Now the change in government in Greece has bought to the headlines the fact that this sort of debt level is not sustainable, unless someone else makes your debt effectively interest free. The Greek finance minister wanted to declare the country bankrupt, and accept the debt could not be paid. But the Euro Area partners rejected this, and preferred to maintain the fiction of sustainability. More money for nothing and your debt for free is the solution that has been found to maintain that fiction.  The significance of the recent Greek deal is that things are essentially going to remain that way.

In a speech given in Athens last year, ECB Executive Board member Benoît Cœuré,referred to Rousseau's "veil of ignorance" initial condition for agreeing on a social or fiscal contract, but maybe more to the point would be the "veil of financial ignorance" which surrounds EU decision making, and effectively means the majority of citizens have little idea of what is really going on. Some even talk of "protecting taxpayers' money in Greece" in relation to the EFSF loans, as if some actual money -rather than debt instruments and guarantees - had changed hands. Greece isn't going to pay back its debt to the official sector, nor will Euro partners ever have to recognise losses on money they haven't actually leant: the ECB can buy EFSF bonds to the appropriate amount and the matter will rest there, possibly with the bonds being renewed every 20, 30 or even 50 years.

So then work down the queue, to Portugal and Italy with gross sovereign debt levels of around 130% of GDP and rising.These debt levels are not sustainable either, unless that is someone is going to relieve you of your interest service charges, in which case such debt becomes merely an accounting problem. Enter the ECB.

But for the same reason I mentioned in the Japanese case, once the central bank has bought sufficient quantities of this debt, I simply don't see how we can ever move back to the initial position, without at least serious debt restructuring. The respective economies simply couldn't stand it. Italy's long run trend growth rate is nearly negative, and Portugal's isn't much better.

All of this will make policymakers in Portugal and Italy very wary of any kind of Euro exit, and increasingly so as debt levels and ECB bond purchases increase.

Favorable Winds Move All Boats

The Euro crisis has come a long way since the heady days of May 2010. A large part of the transition which has taken place has been the responsibility of one man: Mario Draghi. First through his "whatever it takes" speech of July 2012, which marked a watershed in the crisis, opening the period of declining sovereign bond yields. And secondly in a key speech made at the central bankers forum in Jackson Hole in August 2014.  This speech - which was actually rewritten during the gathering with the ECB having to amend the original version on its website - was historic in that it was the first time the ECB President explicitly recognized that Euro Area 5 year inflation expectations were not "well anchored". It thus paved the way for the eventual introduction of QE.

The speech was also important since he laid down a three point plan:

i) monetary easing at the central bank
ii) structural reforms by national governments
iii) expansionary fiscal policy in those countries which had "fiscal space" - ie capacity to run higher deficits.

This plan looks very much like a Euro-specific version of Abenomics "light". Progress has been made  on the first two points, but so far the response from Germany on the third item has been less than negative. In fact the country is proudly paying down its debt. Without taking this situation into account it is impossible to understand what has happened over the last few days with regard to the Greek bailout negotiations.

Billed widely in the press as a "great" victory for Germany, and a major humiliation for Syriza the outcome is in fact neither. The main victors (if such a name be relevant) have been - oh irony of ironies - the Troika (henceforth known as "the institutions"). In fact we are talking about the ECB (Mario Draghi), the IMF (Christine Lagarde) and the EU Commission (Jean Claude Juncker). There is basic agreement between the leaders of these three institutions that Greece was subjected to excessive austerity at the time of its first programme (the IMF have even made self-criticism over this), and that at a time of extended low inflation/deflation and worries about the settling in of deflation expectations further austerity is inappropriate.

Draghi's Jackson Hole plan is in reality the plan of Christine Lagarde and Jean Claude Juncker as well - indeed Draghi even explicitly mentions Juncker's 300 billion Euro insfrastructure plan in his August speech, so it would not completely surprise me to find that the ECB EU institutional purchases involved some related to the European Investment Bank and its financing of the project.

If you add to the Troika the "coalition of the willing" lead by Francois Hollande and Matteo Renzi (both of whom want some deficit relaxation) it isn't hard to see that it was Germany, and in particular the country's finance minister Wolfgang Schaüble, who was isolated, and basically cornered in the Finmin EuroGroup where Germany effectively have a veto (something they don't have on the board of the ECB, which is why much of the current "action" is centered on that institution).

So some sort of coherent policy is now being implemented in Europe in response to the regions long standing low growth issues. It's not clear that the measures being taken will serve to remedy the issues they were brought into being to address, but they will have long term consequences and they will make the currency union participants act more like one coherent whole, and in that sense they are to be welcomed. It may be that there is no real "solution" to the long term deflation issue, in which case other measures will eventually have to be found. But neither is having one weak country after another sliced off and savaged in the bond markets any more satisfactory as an outcome.

What we could be seeing is the birth of a transfer union with the specificity that there will be no actual inter-country transfers. If things are happening in this peculiar way then that will be because this is the EU, and this is how things are done here. It could be, of course, that the basic premiss that contemporary deflation has demographic roots is false. In that case none of this will happen, and put this post down to idle speculation, a mere fantasy world which never has and never will exist. But are you really sure enough that it is false to be willing to do that?


The above arguments are developed in much more detail in the recently revised version of my book "Is The Euro Crisis Really Over? - will doing whatever it takes be enough" - on sale in various formats - including Kindle - at Amazon.

Monday, February 16, 2015

Spain's "Good" Deflation?

Spain's domestic economy is booming, or so the story goes, and in no small part this boom comes thanks to the arrival of what is being termed the "good kind of deflation", the sort everyone would like to have, a world where prices fall, real incomes rise, jobs are created, and everyone gets to live happily ever after. Let's not worry that in the process the boom is steadily transforming an export lead recovery into a domestic consumption - or import driven -  one.

"Deflation is like cholesterol", Economy Minister Luis De Guindos told CNBC at the WEF in Davos, "There are two kinds.....The bad one and the good one. In Spain, you know, we have the good kind," So appealing was the story he told I'm surprised many of those in his audience didn't immediately get on a plane to visit the country to try to discover what the secret was. After all, sounds like the next best thing to a free lunch. Wouldn't anyone want some of that?

Or again, we have Bloomberg's Maria Tadeo, who temptingly informed her readers last week that "Madrid is ready to party again". "A strengthening economy and a pickup in consumer spending," she said, "are energizing nightlife in the Spanish capital after a perfect storm of record unemployment, tax increases and a smoking ban put more than 400 venues out of business since 2008."
Madrid is a great place to be,” said Javier Bordas, owner of Opium, which he plans to open seven days a week. “You’ve got the football players, celebrities, and people love to party. We’re optimistic.” 
It makes you wonder why on earth support for the radical Podemos party is surging at the polls. Surely there must be a catch here somewhere?

Of course, Maria is only covering a story, an upside-bullish Spain-recovery one,  and she does point out that Spain's 23.7% unemployment rate is the second highest in Europe after Greece, but still, it couldn't be that all the intense talking-up of Spain's recovery in domestic demand is also helping to sell some of that 3.34 billion Euros worth of retail commercial property that went under the hammer in 2014, now could it?

Certainly the story must be a lot more palatable to the clique of property consultants who are currently doing the selling than it is to one of the 4 million Spaniards currently on the credit blacklist run by credit consulting firm ASNEF, who normally can't get hold of credit under any circumstances and will have a hard time joining in the current consumer "boom" even if they have a job. Spain's Economy minister Luis De Guindos put it even more graphically: "It’s hard not to defer purchases when you’ve got no money for them in the first place. In the case of Spanish unemployed I think they’ve got more worries than waiting for a new sofa suite to drop by €50."

Nor is the "good deflation" argument especially convincing to anyone with sufficient economic common sense to understand that deflation in a heavily indebted economy can NEVER be unequivocally "good". I doubt there are too many mortgage holders out there busily applauding the ongoing fall in house prices.

If there is such a thing as "good deflation" it surely comes from falling prices in the wake of productivity gains rather than from "downward stickiness" in wages and pensions.  But this is not the Spanish case since employment is growing faster than output. Spain's economy grew by 1.4% during 2014, yet employment was up 2.5%, suggesting that labour productivity actually fell during the year. So Spain's drift downward in prices is being fueled more by a demand shortfall than by supply side improvement: it's hard to see what is so "good" about that.

My intention here, however, is not to argue that Spain's economic recovery has been hopelessly one sided, which it has, but rather to try and pick my way through the ideologically-loaded minefield of arguments which are currently being advanced about the significance and meaning of the deflation phenomenon in Spain.

So, Is Deflation A Problem? 

"Deflation is a protracted fall in prices across different commodities, sectors and countries. In other words, it is a generalised protracted fall in prices, with self-fulfilling expectations. Therefore, it has explosive downward dynamics." - Mario Draghi
One of the reasons the arrival of deflation in Spain has generated so much controversy, I think, is that many doubt the country is actually suffering the phenomenon at all (see Bank of Spain Governor Mario Linde, "deflation risk in Spain continues to be low - November 2014 - or Economy Minister Luis De Guindos, "Spain is not at risk of sliding into deflation" - December 2014). Beyond policy makers and those whose job it is to "talk up" the Spanish recovery there is also little perception that it is a real issue, possibly because many have come to doubt so many of the things the administration says that they aren't even sure yet prices are falling. Beyond petrol and house prices the fall is so small it's not easy to perceive, especially when reductions are not shown in the form of like for like changes, but in the form of more complex "offer" and "discounts".

In fact statistics show that consumer prices were down in January by 1.5% over January 2014, while the GDP deflator for the whole of 2014 (the figure that is used to estimate the impact of inflation on overall output) was estimated at minus 0.7%, meaning that the inflation corrected rise in GDP of 1.4% was only half that number, so, statistically speaking at least, it is important.

But beyond those who simply - perhaps for definitional reasons - doubt that Spain is experiencing deflation rather than simple disinflation there are those who doubt falling prices really constitute a problem. This is the so-called "good deflation" argument. The FT's Tobias Buck sums up many of the arguments in his article "Spanish Consumers Defy Deflationary Gloom",and economist/blogger Shaun Richards has a more theoretical version of the argument here.

The gist of the "good deflation" case is pretty simple: on the one hand countries like Spain need falling prices and some kind of "internal devaluation"  in their ongoing attempt to restore international competitiveness, and on the other consumers aren't "so" rational as to engage in long and complex calculations across infinite time just to work out whether it is better to purchase now-or-later  products whose price is falling by only 1% a year.

At this point it is perhaps worth noting what Mario Draghi says deflation is. Deflation, he tells us, "is a generalised protracted fall in prices,  accompanied by self fulfilling expectations which has explosive downward dynamics".

Well in this sense little in the way of conclusions can be drawn from Spain's initial contact with falling prices, since hasn't been that protracted (yet) and certainly has not developed self-fulfilling expectations: most people in Spain regard the situation as transitory. The self fulfilling part of the definition relates to the possibility of a downward wage-price spiral which mirrors the kind of spiral we see under inflationary dynamics but in the opposite direction. As prices fall, then wage reductions can be offered - as we have seen in Japan - to maintain real wages constant and these wage cuts then fuel further drops in prices. None of this is very evident in Spain so far, even if wages have fallen at some points in the crisis, and with this being election year, the process is unlikely to take hold in 2015.

As for the "explosive dynamics", I presume the explosive part refers to the impact of a wage price downward spiral on debt affordability, since debt to income ratios are constantly pushed up.

The idea that economies move into an outright contraction spiral simply because a small fall in prices is repeated over a number of years is a curious one, whose origin isn't clear, and whose reality is to some extent denied -  as FT Alphaville's Matthew Klein points out in a post entitled "Did Japan Actually Lose Any Decades" - by the fact that Japan's economy is widely believed to have performed "tolerably well" all through the deflation years, with weaker consumption growth being more due to declining population (a problem which may also affect Spain in the future) than it is to a supposed phenomenon of  "purchase postponement". It's only when you start to look at Japan's 245% debt to GDP level that you get to see where there might be a problem.

Even in the case of technological products, where price falls are constant and significant, people seem more likely to look for a combination of price and  performance, since improvements are ongoing and unending, yet people do buy.

 So if people are largely agreed that small but constant price falls don't, in and of themselves, produce widespread purchase postponement, and recognize in addition that Spain needs weaker inflation than Germany, then, you might ask yourself, why on earth are policymakers worried by the phenomenon? Yet worried about it they are, since if they weren't why would the German government be acquiescing in sovereign bond purchases at the ECB (which in principle it is opposed to) to try to stop it digging in for the long haul?

Assuming you don't write this institutional concern off as yet another example of things only economists worry about, and go on to ask the question you are likely to encounter three basic explanations: i) not all price falls are small, ii) there is an interest rate impact and iii) those who are burdened by debts become even more burdened as time passes.

Purchase Postponement in Housing

Spanish housing offers us a clear example of something whose price has fallen considerably, around 40% since the 2007 peak, and whose price continues to fall (currently in the 3% to 5% per annum range).

Far from this fall in prices having stimulated demand - the deflation "consumption boom" argument - we are witnessing exactly the opposite effect: demand has collapsed, and is not recovering significantly (see my piece from April 2014, "Firmly Anchored Expectations, No Postponement of Purchases?"). This is not surprising, since housing is a special sort of good (combining both use and investment) and the market is one where price movements tend to be self re-inforcing.

The Spanish housing market is still far from functioning normally - the number of new houses purchased in December was just over 7,000 - the lowest monthly level in more than a decade.

True, the number of second hand houses being purchased is rising, but even the combined total is far from showing a sharp rebound.

Perhaps the most worrying thing about the fact that second hand purchases are improving while new ones aren't is that part of the explanation for this is that properties become reclassified as "used" 2 years after completion (so some of the second hand houses being sold are in fact new), but this makes the situation with new houses deeply preoccupying, since there are more than half a million unsold housing units still classified as "new" (see this article on the Spanish property website Idealista) which means they have been built within the last two years.

The problem with the arrival of deflation in Spain is this is going to create an environment where it becomes even more difficult  for the housing market to really recover. In the meantime, constantly falling prices have had one consequence: Spaniards now prefer renting to buying, they have become more aware of the risk involved in owning a property. So perhaps rather than simple purchase postponement process what we should be looking for are a broader set of behavioral changes over the longer term.

In any event, given the importance of the Spanish housing market to the economy in general - 75% of the country's household wealth is tied up in property - the situation cannot be ignored: ending deflation in Spain would help push house price movements back into positive territory, and in so doing would give a significant boost to the Spanish economy.

Then There Are Borrowing Costs

Moving beyond the issue of the supposed "purchase displacement effect", Mario Draghi has a rather more powerful argument: the interest rate impact. Consumption growth in modern economies is as much about credit as it is about spending from current income. Too many people are still thinking about economic dynamics in terms of confidence and  money stored under the mattress, or as some whit of a Bloomberg journalist put it, burying it beneath bathroom tiles. Credit matters to modern economies, as we have seen during the recent "credit crunch". As consumer credit accelerates, economies grow, and normally when this happens central bankers started raising interest rates to slow credit growth. In general I think it is fair to say that those who think there is "good deflation" in Spain and those who think Spanish deflation is "not so good" agree about this.

Yet credit, curiously, is all about the temporal displacement of purchases. When credit is cheap, and inflation is expected to be present, consumers tend to advance purchases. I don't know whether anyone wants to challenge this, but it is the cornerstone of any kind of interest rate policy. It is what gives the central bank, under normal conditions, the ability to apply counter cyclical policies in the face of recession. If this mechanism doesn't work, then there is a problem in the whole way we have been thinking about things.

Once interest rates reach the zero bound (I think it is impossible to separate discussion of deflation from the issues which arise in the context of a zero bound) then this mechanism hits a limiting factor, since while prices are in negative territory conventional central banking theory makes bankers reluctant to follow by taking interest rates even deeper into negative territory (although, it should be said, we are now increasingly seeing the negative nominal interest rate phenomenon in countries like Sweden, Denmark and Switzerland). As Mario Draghi put it answering questions at the ECBs December 2014 press conference:
 "Now, let me make absolutely clear that we won’t tolerate prolonged deviations from price stability, and the main reason is that if these deviations feed into inflation expectations, they’ll cause a drop on medium to long-term inflation expectations, which by the way still are within a range consistent with medium-term price stability. But if these were to feed into inflation expectations, these lower outcomes of inflation, were to feed into lower inflation expectations, we would have a zero lower-bound nominal interest rate. This would be tantamount to an increase in the real interest rate."
Here we find some key word expressions: prolonged deviations from price stability, lower long-term inflation expectations, increase in real interest rate. This situation is rather different from the one described by the Spanish economist Javier Andrés in the Tobias Buck article I mentioned earlier: “The fall in prices", Andrés argued, " is not strong enough, nor is it perceived to last that long, as to make it worthwhile for consumers to postpone the purchase of goods.” In Spain at the moment the deviations from price stability have not been strong enough or perceived to have lasted long enough to have an impact on consumer expectations.

In fact  deflation has been settling in for a lot longer than people in Spain think it has. Many still believe that the recent negative inflation is simply the result of a negative oil price shock, but if we look at the EU HICP rate excluding energy it is clear that the deflation issue started a lot earlier.

 Another issue which has clouded the Spain deflation issue has been the use of consumption tax increases as a deficit reduction measure.The national statistics office maintain an ex-tax estimated EU HICP inflation rate, rather like the one the Bank of Japan maintains following the consumption tax rise in that country. Obviously if you raise a consumption tax you raise inflation, but this kind of inflation is not thought to be positive (as we are seeing in Japan, the country fell back into recession after the increase) as it weakens consumption (as the various VAT rises have in Spain).  

The ex-tax consumer price index tries to estimate underlying inflation without the tax, and - as the chart below reveals - if we use that measure Spain has been hovering in deflation territory since late 2012. However Spain's citizens seem to have a kind of "inflation bias" after many years of highish inflation, and simply refuse to believe that prices really have started falling.

In fact if we now adjust that earlier HICP excluding energy data and produce a constant tax version, we get a chart which looks like this.

This suggests that Spain has been near to deflation ever since the global financial crisis struck, but that the initial recovery produced an inflation surge as wages and prices across the economy reacted upwards  (price rigidity, things going back to normal in terms of expectations). Now that shock has passed and the underlying trend towards deflation becomes obvious.

Mr Draghi is worried (although NOT Mr Linde, or Mr De Guindos, as we have seen) that if the current trend is not corrected Spain's citizens might eventually begin to believe and expect it, which is why he gives more importance to the issue and is taking measures accordingly. Indeed, such is the importance which EU - as compared to Spanish - policymakers give to the issue they are taking the measures even though their mere announcement has started causing a great deal of difficulty for central banks in countries like Switzerland, Sweden and Denmark. Again, it is noteworthy how by and large these central bankers are accepting such difficulties without protesting too much since they understand why Mario Draghi feels forced to implement them.

Mario Draghi argues that falling inflation expectations raise real interest rates by influencing the perceived cost of credit into the future. If consumers anticipate inflation, then that makes borrowing cheaper and people tend to advance purchases. Conversely expected price falls make the cost of borrowing greater, make the desirability of advancing purchases via credit less, and in this sense constitute monetary tightening. I am aware of an ongoing debate about whether interest rates really are a key factor influencing investment decisions, but I have never seen an argument suggesting that the cost of credit does not influence consumption. And so it is in Spain, since the demand for household borrowing is not surging, even though the country's banks keep telling us they are now "ready to lend".

Deflation Favors Savers Not Debtors

Deflation obviously favors those with money in the bank (unless the banks start charging negative rates on time deposits) since the value of money steadily goes up. It is not so kind on those with debts, since as prices and incomes go down, debts remain unchanged and the burden of paying them increases.

Spain is an endebted country - the net international investment position (NIIP) is negative to the tune of around 100% of GDP - so it isn't the first place that comes to mind when you think of some kind of "good deflation" process. Japan, in comparison, has a positive NIIP of around 50% of GDP, making it a very different case.

The various sectors in Spain's domestic economy are also very highly indebted, and the combined debt of government, households and the business sector comes to about 275% of GDP, not that much less than it was at the start of the crisis. This is because while household and corporate debt has reduced, government debt has increased considerably. All of this means that if deflation sets in it will be a serious problem for Spain.

Spain's external correction still has some way to go in terms of price competitiveness, but having so called "good" competitiveness recovering deflation is not the way to do it at this point, due to the debt impact. This is why ECB policy is directed towards trying to stimulate Euro Area inflation, since obviously if countries like Germany had 2% annual inflation and Spain and others had 0.5% the correction would be a lot less fraught with problems.

Why Is It Likely Deflation Will Continue In Spain?

There are basically two theories why Eurozone countries are suffering from deflation at the moment. One of these is the idea of debt deflation, whereby over-indebtedness creates a consumption drag leading to a shortage of consumer demand while countries deleverage.  This is certainly part of the problem that Spain is experiencing.

But there is second theory going the rounds ever since it was put into circulation by US economist Larry Summers at an IMF research conference in the autumn of 2013. The hypothesis Summers advances is based on ideas developed by Alvin Hansen in the 1930s, and the essential point is that countries like Japan and those in the Euro Area are experiencing some kind of demographically driven secular stagnation. This is not the place to go into this theory in any depth, but basically the idea is that as working age population growth slows, comes to a halt and then turns negative consumer demand starts to weaken and eventually decline. This affects the investment process, and it is the structural "underinvestment" which produces the demand shortfall which means there is constant downward pressure on prices.

Paul Krugman provides a useful summary of the argument in his blog post - "Demography and the Bicycle Effect" - and I offer a summary here.Of course, at this point it is only a hypothesis - the worrying thing is that in Spain the possibility that this might be happening hasn't even been considered, let alone rejected.

So What Is It - Good or Bad Deflation?

At the moment Spain's citizens have mainly seen only the good side of deflation: wages and pensions were up while prices fell. Spanish hourly wages rose an annual 0.6% year on year in October 2014 (last date for which we have available data) according to Eurostat, Spain's pensions were up 0.25% (despite the pension system running a loss of 1.3% of GDP) while consumer prices were down 1.1% year on year in December. In addition 400,000 new jobs were created during the year. It is little surprise then to discover that the statistics office report that price corrected retail sales were up 1% on the year in 2014.

The question is, what happens next? Do workers and pensioners continue to receive above cost-of-living wage and pension increases? This being election year the chances are they do, which means more pressure on profit margins and more withdrawals from the pension reserve fund. And in the longer run, is this sustainable, or will wages and pensions start to fall in line with prices, producing the so called "spiral"?

To get answers to these questions we will need to wait to see in the years to come, but in the meantime important changes may be occurring in consumer behaviour, not only in attitudes towards house purchase, or in terms of any supposed "postponement" activity, but simply in the way people are becoming more sensitive to price movements and bargains. In this context, Justin McCurry's New York Times article on the Japanese experienece - "Spectre of deflation horrifies bankers, but Japan now has a taste for it - makes interesting reading. In particular his conclusion:
"Spending habits honed over 20 years die hard. And if Japan’s experience can teach Europe anything, it is that government attempts to haul consumers out of the deflationary abyss are fraught with difficulty. An entire generation has come to embrace the deflationary devil they know. For the population at large, what started life as a reluctant thrift habit borne of necessity has quietly become the economic version of the Stockholm syndrome."
And here's another piece of evidence from Japan (The Real Housewives of Japan: Shopping for Bargains … Driving Deflation?) highlighting how years of deflation have lead customers to expect price discounts, and have come to leverage online and social media in the search for ever better bargains.
Could 70,000 Japanese housewives tip this Asian giant into a deflationary spiral? As farfetched as that sounds, it's become a major cause for concern in this nation of 128 million, which has been in an economic funk for two decades. These "real housewives" are part of a user-driven, social-networking site called Mainichi Tokubai, which delivers the best prices on specific grocery-store items to the fingertips of Tokyo-region consumers. To hear frustrated Japanese policymakers and retail executives tell it, these bargain-minded consumers and their equally frugal social-networking site are almost-single-handedly undercutting the Japanese economy.
The above article particularly caught my attention since this is a phenomenon which is increasingly to be seen at work in Spain: people shopping around and expecting bargains, and using online media to help them in their search. In deflationary times the evidence suggests the rise of a kind of "consumer power" where people come to expect permanent sales and discounts and virtually force these on retailers, to the great disadvantage of the small, local shop. This kind of behaviour obviously fuels deflation and when entrenched it is hard to change as Stanley White noted in a 2012 Reuters article.
"A bargain-hunting psychology is so entrenched in Japan — after two decades of stop-start economic growth, 15 years of falling wages and nearly 15 years of deflation — that the government will struggle to convince people that their incomes will improve enough for them to buy more expensive goods.
Spanish policymakers take note, and think twice in future before you say Spain is simply suffering from "good deflation".  


The above arguments are developed in much more detail in the recently revised version of my book "Is The Euro Crisis Really Over? - will doing whatever it takes be enough" - on sale in various formats - including Kindle - at Amazon.