Reflections On Europe's Irrational Deflation Phobia


(emphasis added)

This is what Japan has just experienced: initially, there was a boost to export earnings in yen terms due to the lower yen exchange rate. In the meantime though, prices in Japan have begun to adjust to the situation (the adjustment is still ongoing). Since Japan can be regarded as a kind of 'contract manufacturer' as Kyle Bass recently put it, it is chafing under the strong increases in input costs of raw materials it needs to import from abroad. Not only are the 'advantages' of a lower exchange rate fleeting, they are also unevenly distributed. A handful of exporters – as a rule a very small portion of the total economy, even in an export powerhouse like Japan – may benefit for a while, but everybody else merely can no longer buy as many goods and services from abroad as they could before.

The ECB is also under pressure from numerous bien pensants, many of which are found in its own ranks, to prevent a decline of prices in the euro area. The strong euro is held to play a role in the fact that price increases have recently slowed down. For most of the euro area, falling prices are still only a distant prospect anyway. The few countries in which prices are actually declining slightly, such as Greece and Spain, urgently need lower prices. Naturally the several hundred million consumers in the euro area all benefit from the fact that price increases have slowed, but that is never mentioned. Indeed, in countries like Greece and Spain, where a quarter or more of the working population are unemployed and many people's wages have been cut, falling prices must be considered an extremely welcome unmitigated boon.

Apparently not in the opinion of central bankers though. In his press conference, Mario Draghi made clear that the bank now wishes to see a weaker euro as well, so as to combat 'too low inflation'. The euro promptly fell.



The euro comes under pressure following Draghi's remarks at the ECB press conference – click to enlarge.

Painted Into a Corner?

Several observers have pointed out that Draghi has committed the sin of 'pre-commitment', so to speak 'painting the ECB into a corner', by announcing that the 'ECB was comfortable to act in June'. However, there were conditions tied to this commitment.

According to Marketwatch:

“What had been a rather boring ECB news conference took on new life Thursday when Draghi said that policy makers were “comfortable with acting next time,” but first want to see updated ECB staff projections on the economic and inflation outlook.

The remarks, which came amid laments over how a strong euro was contributing to chronic low inflation and was among downside risks to the region’s economic outlook, ensured the euro not only stopped just short of $1.40 but dropped sharply. (Draghi, of course, reiterated that the exchange rate was not itself a “trigger” for action, but an important piece of economic information.)

The euro sunk to $1.3849 after Draghi’s comments, down about 1.5 cents. It changed hands in recent action at $1.3841.

Yields on so-called peripheral eurozone government bonds continued to fall. Spanish and Italian government borrowing costs have retreated sharply from potentially unsustainable levels well above 6% in July 2012 after Draghi pledged the ECB would do “whatever it takes” within its mandate to preserve the euro. That pledge was followed by the creation of the ECB’s bond-buying Outright Monetary Transactions program, though the subsequent fall in yields has meant that the ECB has yet to use it to buy a single security.

Still, economists were quick to argue Thursday that the ECB could conceivably try to wriggle out of what forex traders and the broader market seemed to view as a pretty strong signal the ECB will deliver when it meets June 5.

“In fact, on the back of better-than-expected Q1 GDP data, growth might even be raised for this year. And what if the inflation forecast for 2015 and 2016 remains unchanged? And what if credit growth has improved slightly? It is exactly these uncertainties which kept the ECB from already acting today and might prevent it from acting in June,” said Carsten Brzeski, a Brussels-based economist at ING Bank, in a note. Maybe so, but Brzeski acknowledges it is getting harder for the ECB to keep its “manana-manana” attitude.

The bigger question is what the ECB do given that its official interest rate is just at 0.25%. Since Draghi has signaled the ECB wants to use up conventional measures before delving into the unconventional, another rate cut could be the first step, notes Gary Jenkins of LNG Capital.

Beyond that, there are the usual suspects that have been trotted out ahead of recent ECB meetings: a negative deposit rate, halting the sterilization of earlier bond purchases made under the ECB’s old Securities Markets Program, long-term refinancing operations and even outright quantitative easing.”

(emphasis added)

Here is a video by Saxo Bank, in which its analyst Nick Beecroft discusses the probability of the ECB introducing negative deposit rates:


Nick Beecroft of Saxo Bank believes the ECB will move to a negative 25 basis points deposit rate at its next meeting in June and will eventually impose up to 100 basis points in 'penalty' rates.

'Obsessed With Low Inflation' – Signs of Insanity

As Beecroft remarks, the “ECB members are becoming obsessed with low inflation and the strength of the euro”. In other words, they are in the grip of insanity. The psychological condition they are suffering from is known as Apoplithorismophobia, and there is no known treatment. As Mark Thornton (who coined the term) points out, this form of mental illness only afflicts policymakers, financial journalists and a number of economists. The general public is usually completely unaffected.

The root cause of the phobia is misunderstanding the causes of the Great Depression (see 'depression expert' Ben Bernanke as an example) and on a more general level, the failure to distinguish between what is 'seen and what is unseen', a topic discussed extensively by French economist Frederic Bastiat almost 170 years ago. Thornton writes:

 Apoplithorismosphobia (ay-pope-lit-horris-mos-foe-be-ah) is the fear of deflation. Or, more correctly, the fear that an economy would “suffer” from falling prices, or a general decline in the prices of goods and services.

It is a fear that has gripped some economists, journalists, and policymakers with a blinding strength as powerful as faith. Evidence seems to suggest that the phobia develops from the inability to understand the causes of the Great Depression and a more general failure to distinguish between what Bastiat called “the seen” (e.g., deflation) from “the unseen” (e.g., the causes of contraction and unemployment).

Under the influence of this phobia, victims develop an unfounded faith in the ability of monetary and fiscal policy. In extreme cases it leads to the support of powerful policy “weapons” to combat deflation—the equivalent of using economic weapons of mass destruction.

As shown in the case of Japan, this behavior is counterproductive and should be considered a danger to society. The purpose of this paper is to describe and diagnose this phobia and to present a treatment to counteract its effects. The phobia seems to be largely limited to economists, journalists, and policymakers, although labor and business leaders also express similar views. Apparently it does not affect the general public, whose attitudes, views, and actions indicate that they are generally quite attracted to the idea of deflation, especially if the brisk business in places like Wal-Mart and Costco, retailers who specialize in cutting their costs and prices below their competition, is any indicator.”

(emphasis added)

We strongly recommend reading Thornton's paper on the topic, which explains in a concise and easy to grasp manner why this phobia is a danger to society at large and why those afflicted by it are completely misguided.

As we have often pointed out in these pages in the context of protectionist demands uttered by politicians (such as e.g. the demand that China must increase the exchange rate of the yuan), they are the equivalent of Wal Mart's customers storming the offices of the company's management and shouting “Raise your prices immediately, or else!

We would obviously regard such behavior on the part of Wal Mart's customers as utterly insane, but when politicians, economists, journalists and/or policymakers display similar behavior, we are for some reason supposed to nod our heads in agreement.

The Effect of Lowering the Deposit Rate Into Negative Territory

As to the practical significance of lowering the deposit rate paid on excess reserves into negative territory, it is difficult to see what it is supposed to achieve. To minimize the impact, banks can for instance simply transfer funds from the ECB's deposit facility into the current account facility, as they have already done with the bulk of their reserves when the rate was cut to zero.

It most definitely isn't going to be an incentive for them to increase their inflationary lending – on the contrary, since they are going to begin losing money on excess reserves they leave in the deposit facility, they will become even more cautious.

What's more, there is currently no 'credit crunch' in the euro area anyway, as evidenced by the absurdly low levels to which the yields on the sovereign debt of the former crisis countries have fallen (in spite of their debt-to-GDP ratios deteriorating further at quite a rapid clip). There simply is very little demand for credit at present. There is now much less credit required for every euro of economic growth than before, a fact one should rejoice in.

It is in fact erroneous to believe that inflationary credit expansion 'helps' the economy to grow. On the contrary, it undermines the economy structurally, by falsifying economic calculation and provoking the malinvestment of scarce capital. This can by the way also be shown empirically: the economies of the Western industrialized nations grew much faster before unfettered credit expansion began  following Nixon's gold default in the early 70s than thereafter. It simply makes no sense to attempt to spur inflationary credit growth – there is neither a theoretical nor an empirical case that can be made in favor of such a policy. 


Spain., 2yr. note yieldSpain's 2 year note yield: no credit crunch in evidence – click to enlarge.


In short, the ECB has actually done the best thing it could do in recent months, namely nothing. Should it once again become activist at its next meeting, it will only manage to harm the economy's long term prospects. The things the euro area needs most urgently are a rollback of regulations and bureaucratic red tape as well as lower taxes. As we have pointed out before, deflation is not a 'danger'  that needs to be fought and neither is there a need to try to lower the euro's external exchange rate. One cannot get more prosperous by means of debasing one's money.

Published by Acting Man. View original post.



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