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Oil fall adds to ECB’s deflation worries
From the Financial Times of Tue, 23 Dec 2014 08:09:31 GMT

Steep falls in global oil prices are traditionally great news for the world economy and for the oil importers of the developed world. So there are good grounds for rejoicing at the near halving of oil prices since their June peak. An added bonus for the west is geopolitical: some of the world’s least attractive regimes — Russia, Venezuela, Iran — are taking a beating as their oil revenues shrink, though any satisfaction has to be tempered by a recognition that collapsing economies can drive wayward regimes into dangerous foreign policy adventurism.

There are economic reasons, too, for thinking that this oil price decline, while positive overall, may prove less beneficial for growth than in the past, not least because the eurozone economy is confronting deflation. A decline in oil prices adds to deflationary pressures. Yet the super-cautious monetary instincts of the German Bundesbank constrain the European Central Bank’s ability to address the problem — witness the ECB’s crab-like moves towards full quantitative easing, including the purchase of sovereign bonds.

Northern Europeans could, of course, argue that Japanese experience shows that deflationary threats are greatly exaggerated. Deflation in Japan has been mild and in per capita terms growth has been healthy over the past two and a half decades since the bursting of the Japanese bubble. During that time household savings have fallen to negligible levels, which hardly suggests a deflationary mentality whereby consumers put off purchases because they expect prices to be lower in future. The deflationary mentality is more evident in the corporate sector where companies have been refraining from investment and saving to excess, but that can readily be addressed through tinkering with the tax system.

Even so, Japan’s demography, with the oldest population among the large advanced countries, makes comparisons potentially misleading. The net figure for household saving may combine disparate phenomena — a growing army of retired people dissaving furiously to supplement their meagre pensions, while a shrinking workforce defers consumption because of continuing fears of deflation.

In the eurozone, meantime, deflation is already a reality for the harder hit countries. It is also a looming threat for those economies that are ostensibly more healthy. The risk is that deflationary expectations are becoming entrenched to the point where they could become self-fulfilling, with less spending leading to even less inflation or falling prices. Barry Eichengreen, an economist who has done extensive analysis of the 1930s Depression, points out that deflationary expectations can be transformed into inflationary expectations — thereby encouraging more spending — only by policies that induce shock and awe. Really dramatic measures are needed to convince households and companies that the future will be different from the past.

Back in July 2012, Mario Draghi, ECB president, showed what shock and awe could achieve with his “whatever it takes” commitment to stop the unravelling of the monetary union. In today’s circumstances, shock and awe would mean a fully committed move to US-style quantitative easing. It is hard to see how else the ECB could meet its inflation target of below, but close to, 2 per cent, particularly now that the oil price is plunging. Yet the Bundesbank poses a formidable obstacle to such a commitment, worrying about inflationary implications despite the palpable slack in the eurozone economy.

At the same time, northern Europeans fear full QE will make it easier for governments to put off fiscal consolidation and structural reform. Yet both are deflationary in the short run. In an economy with considerable slack employers will cut wages, while increased competition would cause the prices of goods to fall. There is, of course, a rational case for fiscal consolidation and structural reform, but northern Europe is failing to grasp that there is a sequencing problem. These policies cannot be effective unless the deflationary dragon is conquered first.

To stand any chance of working — which will be difficult in a eurozone economy dominated by bank lending — a government bond buying programme needs to be big and wholehearted. Instead the ECB is condemned by the northern European culture of fiscal and monetary caution to incrementalism. Unless Mr Draghi can find a way through this intractable political logjam — which even for a man of his remarkable political skills seems somewhat implausible — the ECB’s unhappy lot will forever be to deliver too little, too late.

The writer is an FT columnist

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