“Houston, We’ve Had a Problem”
June 9, 2014 --
In America’s space program, the Apollo 13 mission is legendary. This third attempt to land people on the moon suffered a near-catastrophic operational failure that imperiled the lives of its three astronauts, who spent a harrowing five days improvising to guide their damaged ship safely back to earth. Commander James Lovell famously alerted Mission Control in Houston—and the entire world—to the danger at hand with the laconic quote, “Houston, we’ve had a problem.”
Last Thursday, president of the European Central Bank Mario Draghi had his own “Houston, we’ve had a problem” moment. He announced to the world dramatic changes in ECB policy, perhaps most radically that the ECB is reducing its “deposit rate” that it pays on overnight deposits kept at the ECB by banks to minus 0.10 percent. That’s right: the ECB is now charging banks, not paying them, to take their deposits. What problem has prompted such aggressive moves? The specter of deflation.
Last Tuesday, Eurostat announced that in May the year-over-year rate of consumer-price inflation in the 18 countries of the Euro area fell to just 0.5 percent, from 0.7 percent in April. In Portugal and Greece deflation—i.e., negative inflation rates, meaning the general level of prices is falling, not rising—has already taken hold, and deflation is very close in countries including Italy, Ireland, and Spain.
Why are falling prices a bad thing? Well, sometimes they aren’t. Sometimes prices fall thanks to big technological gains—often linked to global connectivity—that spur sufficiently large increases in output relative to demand. Innovation-driven deflation can be a good thing: think of the ongoing plunge in prices for information-technology products such as your iPhone, your Galaxy, your laptop computer, and the like. From 2000 through 2013, the U.S. consumer price index for personal computers and related products tumbled by a remarkable 87.7 percent.
But sometimes prices fall because of a slump in demand, not an innovative burst of supply. And when throughout an economy demand slumps for so many goods and services that aggregate price indexes begin falling rather than rising, trouble looms. Businesses and households that cut demand so much that overall prices fall often begin postponing purchases because of the value of waiting for lower prices tomorrow. Thus can deflation feed into gloomy expectations and become self-reinforcing—with continued downward pressure on output, investment, jobs, and income. No disrespect to the good country of Japan, but Mario Draghi is hoping to avoid the many problems of deflation with which Japan has struggled over the past generation.
Will a negative deposit rate and other ECB efforts forestall deflation? Maybe. In principle, the negative deposit rate will induce banks to stop leaving deposits with the ECB and instead lend them out to companies and households—and thereby boost demand and prices. In practice, the quantity of such affected deposits is not large, and other forces such as ongoing healing from the crisis continues to constrain bank lending in Europe.
What is clear is that short of starting quantitative easing—i.e., short of large-scale asset purchases—the ECB is out of stimulus options. Thus did Mario Draghi acknowledge on Thursday that, “For all practical purposes, we have reached the lower bound.” The Apollo 13 crew avoided astronautical disaster only with the creative assistance of hundreds of experts back on earth in addition to their steely efforts. For Europe to avoid deflationary disaster, Mario Draghi and colleagues will need similar help from policy makers beyond the ECB.
Articles © 2014 Matthew Slaughter and Matthew Rees. All rights reserved.
Publication © 2014 Trustees of Dartmouth College. All rights reserved.