German Bundesbank Joins The ‘Fight Against Deflation’

Nonsense Proves Contagious

For a long time, the BuBa was held to be the main defender of anti-inflation orthodoxy in Europe. One must keep in mind here that Germany has had very bad experiences with inflation in the past. The WW1 wartime inflation was bad enough, but it was followed by the famous hyper-inflation episode of the Weimar Republic, which caused such large-scale misery that it has remained etched in the German psyche ever since. Partly this catastrophe occurred because the Reichsbank's council had warmed to the ideas formulated in Georg Friedrich Knapp's book 'The State Theory of Money'. Readers may be familiar with the modern-day version of Knapp's chartalism, the so-called 'modern monetary theory' (MMT). In a nutshell, Knapp and the chartalists are certifiable monetary cranks (if you want to see more polite and extensive criticisms of chartalism, we recommend these articles by Bob Murphy and Robert Wenzel).

Anyway, the people that have imbibed the Bundesbank's institutional tradition no doubt regard the Weimar hyper-inflation as a kind of 'Ur-catastrophe'. It is e.g. widely held that the monetary breakdown of 1923 created the conditions that eventually brought Hitler to power. This may be debatable to some degree, as  the governments that were in charge between the inflationary conflagration and Hitler's power grab made a great many mistakes as well. However, it is certainly true that widespread economic misery greatly helped the Nazis, not least because they were able to present themselves as the only force that could reliably keep Germany from succumbing to a communist revolution.

Current BuBa president Jens Weidmann has long been considered as standing between the more ambitious money printing plans of the 'Southern Bloc' on the ECB council, but apparently this is no longer the case. We previously argued that he may merely be playing along for tactical reasons, and it may well be that such considerations indeed play a role in the BuBa's changed stance. However, it does appear that the nonsense about the alleged need to 'combat deflation' is contagious and that the BuBa has been infected as well.

The WSJ reports:

“Germany's central bank is willing to back an array of stimulus measures by the European Central Bank next month if needed to fight unacceptably low inflation, underscoring the Bundesbank's shift away from its reputation in recent years as the euro zone's policy rebel.

The Bundesbank is open to supporting aggressive—and in some cases, for the ECB, unprecedented—steps including negative rates on bank deposits, long-term loans to banks at capped interest rates and purchases of packaged bank loans, a person familiar with the matter told The Wall Street Journal.

The euro fell sharply on the news of the Bundesbank's stance, which lends support to mounting expectations in financial markets that the ECB will act decisively, and with unity, on interest-rate cuts and other measures when it next meets June 5.

Projections by ECB staff on inflation for 2016, which central-bank officials will have in hand when they meet, will be central to the Bundesbank's decision on additional stimulus moves, the person said. But the German central bank's readiness to act marks the clearest sign yet that the Bundesbank—in recent years defined by its conservative opposition to the ECB's emergency measures to combat the euro-zone debt crisis—is fully engaged in fighting too-low inflation in the euro zone and open to using monetary-policy tools.

The Bundesbank's position also signals a return to the fold for its president, Jens Weidmann, whose three-year tenure heading Germany's revered central bank has often been characterized by his fierce opposition to the ECB's main anticrisis policy: an open-ended bond-purchase plan launched in 2012 to stabilize bond yields of stressed euro-zone members. The conservative German central bank regards the program, though never tapped, as a dangerous mix of monetary and fiscal policies. Though the Bundesbank has been inching away from its opposition role and toward greater backing of ECB policies for nearly a year, the revelation of its low-inflation stance now serves a number of strategic issues for the central bank.

Tactically, a more flexible approach could benefit the Bundesbank by making its views more relevant in financial markets after finding itself largely isolated in its objection to previous efforts to ease market fears of a euro breakup. That, in turn, could strengthen its hand when it opposes such measures as large-scale asset purchases.

"They realize that they have a much stronger position if they come up with a list of proposals for what the ECB can do," said Carsten Brzeski, economist at ING Bank. "It's a more productive approach than the always-saying-no approach."

The Bundesbank's backing could provide critical support for ECB President Mario Draghi when the bank meets next month to weigh interest-rate cuts and other stimulus measures. Mr. Draghi put financial markets on notice last week that additional measures were possible in June amid weak annual inflation which, at 0.7% in the euro zone, is far below the ECB's target of just under 2%. Germany's inflation rate is slightly higher than the euro-zone average.

Central banks—particularly the inflation-wary Bundesbank—typically strive for low growth in prices, which keeps borrowing costs down and provides a stable backdrop for households and businesses to spend. But when inflation is too weak, debts become harder to service, and consumers may put off purchases in the hope that prices will fall. ECB officials have also made clear they are concerned about the high value of the euro, which weakens inflation.”

As Mish recently pointed out, French politicians are at the forefront of the 'we need a weaker euro' brigade,  which is perhaps not a big surprise considering that Mercantilism was a French invention and first implemented in France, with predictably disastrous results.

Keep in mind that less than two years ago, many were still convinced that the euro would soon implode and break apart. A chart of Spain's two year government bond yield illustrates the situation:

Spain's 2 year government note yield. Less than two years ago, there were still grave doubts as to whether the euro would survive at all – click to enlarge.

In light of this, it is downright comical that both EU politicians and members of the central bank council are now eager to step up measures to weaken the currency. Shouldn't they be glad that market confidence in the euro has returned? Why endanger it by weakening the currency?

Almost needless to say, it is simply not possible to become wealthier by means of debasing one's money. As Mish also points out in his article, even if it were sensible,  it is a strategy not everybody can implement at the same time. How can Japan, the US, China and euro-land all debase themselves to prosperity by weakening their currencies concurrently? It simply makes no sense.

The Deflation Bogey

There can be little doubt that credit growth in the euro area is weak. So what? Everybody should be glad that it is. After all, it was unfettered growth in credit and the money supply that brought about the crisis. Why is it apparently held that it would be a good idea to rekindle the boom-bust cycle by once again artificially boosting credit growth? If people don't want to borrow more money, why do the bien pensants infesting the central bank believe it is their job to 'know better'?

The WSJ article included the following chart:

Credit in the euro area is contracting, which is allegedly 'bad'. Similarly, it is considered 'bad' that in a handful of countries, prices are either not rising much, or declining ever so mildly.

This does not unfortunately not mean that there is actually 'deflation' in the euro area as we will show further below. The euro area's money supply continues to grow at a fairly brisk rate. There is no reason whatsoever to 'fear' deflation in the sense of declining prices either.

The often heard arguments that are parroted in the WSJ as well can be easily refuted. People do not stop consuming just because prices are declining. If that were the case, no TVs, computers, smart phones, tablets, etc. would have been sold in recent decades. After all, their prices are declining continually. And yet, in spite of the fact that one does not need these goods to survive, people do in fact buy lots of them. Past price trends are just one of the things informing people's expectations about the future, but they are by no means the only one. How people will react to certain developments is difficult to predict, as it depends on many unforeseeable contingent circumstances. For instance, there has been no rush to take on additional debt, in spite of central banks manipulating short term interest rates to zero.

However, the biggest problem with the fear of deflation remains the idea that there won't be 'enough spending'. It is erroneous to believe that spending on consumer goods is a measure of the economy's health. 'Spending' in this sense does not create economic growth. When people are saving rather than spending their money on consumption, it is simply the composition of spending that is altered. The money saved will be invested, i.e., instead of being spent on consumer goods, it will be spent on capital goods in the higher stages of the production structure. The result is that the economy becomes more capital intensive and productive. Production will therefore increase, which ultimately makes more consumption in the future possible. By saving rather than consuming, people are simply signaling their time preference – they prefer to consume less today, so as to be able to consume more in the future.

Euro area, money TMS. The year-on-year growth rate was recently just below 6%, in spite of the reduction in inflationary lending to the private sector. The culprit is ongoing monetization of government debt by commercial banks in the euro area.  The rate of growth of the money supply remains quite brisk – there is definitely no monetary deflation in the euro area at present – click to enlarge.

In addition to the theoretical objections to 'deflation paranoia', there ironically exists a study done by central bank economists (pdf) that shows that there is actually no empirical evidence that would support the contention that deflation 'causes depressions' either. The study was published in 2004, and the authors are economists working for the Federal Reserve of Minneapolis. Here is what one could so to speak term the 'money quote' from the study:

“There are 65 episodes of deflation without depression and 21 of depression without deflation. Thus,65 of 73 deflation episodes had no depression, and 8 of 29 depression episodes had no deflation.

What is striking is that nearly 90% of the episodes with deflation did not have depression. In a broad historical context, beyond the Great Depression, the notion that deflation and depression are linked virtually disappears.”

In short, there is definitely no need to 'fight deflation'. The policy makes no sense regardless from which angle it is examined.

Proposed Measures

Lastly, the WSJ article also informs us of what monetary pumping measures the BuBa would reportedly support. Apparently Fed or BoJ type 'QE' is not among them, but this hardly matters considering what it would agree to:

“But the Bundesbank's backing of new measures has limits. It remains resistant to large-scale purchases of public and private debt, known as quantitative easing, the person familiar with the situation said. The German central bank has discussed this option internally but has concluded that with government and corporate bond yields already quite low in Europe, the purchases wouldn't do much good and could instead create financial-stability risks.

But the Bundesbank is open to a significant package of measures, the person said, including reductions in the ECB's lending and deposit rates; extension of unlimited loans to commercial banks—known as fixed-rate, full-allotment loans—from mid-2015 until mid-2016; offering new long-term loans to banks at a fixed rate to further beef up the ECB's forward guidance; and some purchases of asset-backed securities.

But even without the large-scale asset purchases, the Bundesbank's list would pack a punch. No central bank as large as the ECB has experimented with a negative deposit rate—the ECB's rate is currently zero—which would effectively penalize banks for parking surplus funds at the ECB. The euro would likely cheapen as international investors cast a more wary eye on euro-denominated assets.

Meanwhile, extending the ECB's provision of unlimited loans to banks well into 2016 would further cement the notion that the ECB will be far behind other major central banks, such as the Federal Reserve and Bank of England, when it comes to eventually raising interest rates.

The Bundesbank is also open to extending additional long-term loans to banks at a capped rate, meaning banks could tap the ECB for funds without worrying about future interest-rate increases, the person said. Another option, the person said, would be to better target ECB loans to the private sector.”

We already discussed why introducing a penalty rate on excess reserves held at the ECB makes no sense, even from the point of view of the pro-inflation camp. If the ECB were to e.g. start buying asset backed securities with money from thin air (one of the proposals mentioned above), commercial bank reserves at the ECB would automatically increase. What would be the point of penalizing banks for holding reserves they only hold as a result of the central bank's own policy? Not to mention that they could evade the penalty anyway (see our previous article).

Regarding the extension of long term ECB loans at a capped rate, the idea is obviously to boost credit growth, but the underlying assumption that there is a credit crunch in the euro area is  actually wrong. The main reason for the decline in credit growth is a lack of credit demand. Individuals and companies alike are not interested in taking on more debt. Again, the assumption that the central bank must intervene to 'fix' that is utterly absurd.

Conclusion:

All over the industrialized world it is held that there is a need for central planning of economic activity at a fundamental level, by fixing the price of credit and pumping up the supply of money. The idea seems to be that the voluntary decisions of actors in the economy must be overruled by means of intervention 'for their own good'.

It is of course only natural that the bureaucrats doing the planning and their advisers would think so, since otherwise they would have to admit that they are surplus to the economy's requirements. And so we continue to lurch from one giant boom-bust cycle to another. 

Charts by: bigcharts, WSJ, ECB