Summary:
– Low inflation complicates the reduction of public debt and the adjustment of relative prices and wages within the eurozone.
– Monetary policy is effective, but it cannot do everything.
– The Juncker plan is a step in the right direction, but is likely to have a limited effect.
– Several structural reforms are possible to boost growth and inflation in the medium term, with a limited negative impact on inflation.
The annual country risk conference organized by Cofacetook place on Tuesday, January 27, 2015, at the Carrousel du Louvre. Jean Pisani-Ferry, Commissioner General for Strategy and Forecasting, opened the conference with a speech on deflation. He believes that deflation is indeed a threat, but that the more pressing issue is to address the problem of low inflation. With the price index at -0.6% in January, the ECB’s target of 2% seems a long way off.
First and foremost, the question arises as to why central banks have a non-zero inflation target. Firstly, to be able to absorb a deflationary shock without inflation automatically falling into negative territory. But also to allow nominal income to grow so that the debt ratio ( debt/GDP) does not become too heavy (deflation is characterized by a decline in GDP, leading to an increase in the debt ratio). Finally, to facilitate the adjustment of relative prices and prevent this adjustment from taking the form of price reductions.
These three justifications are particularly relevant today:
1. To avoid falling into a deflationary spiral, monetary policy is taking action and doing everything in its power, but its impact remains limited, as Mario Draghi pointed out in Jackson Hole in the summer of 2014. Fiscal policy and reforms are complementary and indispensable.
2. European debt is difficult to reduce in this low-growth environment. The situation in Greece is a perfect example: the debt restructuring carried out in 2012 had a very limited impact on the level of debt due to a sharp fall in nominal GDP, contrary to the Troika’s forecasts. Italy, which has the same nominal GDP as in 2007, also finds itself with a debt that is difficult to reduce.
3. Compared to previous estimates, wage rigidity has been less than expected, while goods prices have ultimately undergone little relative correction (inflation at 3.3% in 2011, 1.5% in 2012, and -0.9% in 2013). The adjustment in Europe has therefore been achieved mainly through relative wages between countries ( the wage index in Greece fell by 24% in four years, while it rose by nearly 10% in Germany, for example). However, Jean Pisani-Ferry believes that the adjustments are not yet complete, as the differences in external balances between eurozone countries remain very significant.
How can this low inflation be remedied?There are two possible courses of action: monetary policy and fiscal policy. The ECB is acting belatedly, but with determination, by launching its large-scale quantitative easing (QE) program on January 22. This QE program, which involves injecting €60 billion per month between March 2015 and September 2016 (for a total of €1 trillion), seeks to revive the credit market, and thus inflation, through two channels. First, by buying massive amounts of sovereign debt securities (€50 billion per month), it seeks to saturate the supply of safe assets to push investors toward riskier markets such as stocks and corporate bonds, in order to promote the financing of the real economy. In addition, €10 billion is also spent each month on purchasing ABS (Asset Backed Securities), with the aim of encouraging financial institutions to grant and structure loans. As for fiscal policy, its use is limited by the size of the debt of many European countries and, when it targets supply-side policies, can have a disinflationary effect. For example, seeking to increase the competitiveness of companies by reducing their costs (wages, taxes) can lead to lower prices.
The Juncker European investment plan seemsto circumventthe limitation imposed by countries’ debt by organizing a recovery on a European scale. However, it remains limited in scope and is based on very strong leverage (€315 billion for an initial investment of €21 billion), which may cast doubt on its real effectiveness, since it is based on the assumption that for every €1 billion mobilized by the European authorities, €15 billion will be added by private investors. And for this plan to be useful, it must not finance projects that would have been launched without it (free-rider effect). It must finance investments that present a certain degree of risk, in order to correct the risk aversion of banks, through public funding.
Other reforms are possible to improve the situation in the short term and increase medium-term growth potential without risking a negative impact on demand and therefore on inflation:
– Pension reform should have a positive effect on demand in the short term thanks to an increase in intertemporal income.
– According to Jean Pisani-Ferry, the Macron law currently being debated in the French Assembly, which includes provisions on Sunday working, industrial tribunals, etc., should not have a negative impact on prices.
– Greater efficiency in the public sector, with improvements to the education system, procedural reforms, etc., should increase growth potential.
Jean Pisani-Ferry has put forward other instruments to combat low inflation and boost growth in the medium term:
1. Redirecting European structural funds, used for regional development policy, towards a European strategy.
2. Developing a European savings policy to redirect savings from northern countries to southern markets and encourage direct investment.
3. Encouraging European cooperation between all stakeholders: monetary policy, national governments, the European Investment Bank, social partners, etc.
Conclusion
For Jean Pisani-Ferry, a coordinated effort between monetary and fiscal policy, jointly undertaken by European states and bringing together all economic actors, must be put in place to avoid this « deflation trap. »
References
– BSI Economics, 2015, » Behind the gloom lies recovery , » Official report of the 2015 Coface Country Risk Symposium, BSI Economics and Coface Group.
– Simon Ganem, 2015, » Is the Eurozone doomed to stagnation? , » BSI Economics.
– Julien Pinter, 2014, » Why is deflation dangerous? , » Insights, BSI Economics
– Pierre-Michel Becquet, 2014, » The transmission of lower sovereign rates to the financing conditions of non-financial companies in France , » Flash, BSI Economics.
– Victor Lequillerier, 2014, » Spain: competitiveness, at what price? , » BSI Economics
