European policymakers no longer able to ignore deflation

EU CPI Jun14A year ago, European policymakers and central bankers were dismissive when the blog suggested deflation was a far bigger threat than inflation – when it was speaking at the world’s major conference for bond investors.  Later this month, the blog expects a different response when returning to speak at the same conference.

Last week, the European Central Bank (ECB) was forced to announce major new measures to tackle the threat of deflation.  It became the first central bank to start charging people interest for looking after their money.  Instead of gaining interest on their deposits, they will be paying 0.1% to the ECB.

What a difference a year makes!

Last June, as the chart shows, Eurozone inflation was 1.6% and appeared to the ECB at least, to be climbing back to its 2% target.  Mario Draghi, the ECB’s head, was congratulating himself on the success of his promise in July 2012 to “do whatever it takes” to restore the Eurozone to economic health.

But now, just as the blog expected, inflation has fallen rather than risen.  It is now just 0.5%.  One relatively small shock in financial markets could easily send it into negative territory.  And developments in China have the potential to be far more than a small shock, as the blog will discuss later this week.

So what should the ECB do, if it is serious about wanting to tackle deflation?  The answer is simple.  It should stop pretending that monetary policy can create demand.  People create demand, not electronic banknotes.

Instead, it should turn round to the politicians and tell them to do something, instead of hiding behind the fig-leaf of monetary policy.

There is only one thing, of course, that they can do at this late stage.  That is to explain to the voters that there needs to be an immediate increase in the pension age across Europe.  Doing nothing will make deflation inevitable, and introduce a downward spiral where people stop spending in order to pay off debt.

As we discussed in chapter 1 of Boom, Gloom and the New Normal:

“When the then German Chancellor Bismarck introduced the first state-funded pension scheme in 1889, average life expectancy in the country was only 47 years.  And Bismarck set the age for receiving a pension at 70 years, expecting no more than a few percent of the population to ever benefit. 

Today, as the blog noted in December, Germany’s median age at 46 years is now virtually the same as life expectancy in Bismarck’s time.  But whilst life expectancy is now around 80, pension age is still the same.  And there are even serious discussions about reducing it to 63!

To put the position in simple terms, ‘you can’t have it both ways’.

Already 40% of the German population is in the low-spending New Old 55+ generation.  And OECD data shows more than one in three of the working age population are now over 65.  This represents a double blow to growth:

  • A large proportion of the population are now out of the workforce, and living on pension income
  • A relatively small younger population (by historical standards) has to support this vast burden of paying for all these pensions

Can anyone seriously imagine that printing banknotes is going to change this situation?  Of course not.  But the politicians do not want to have this difficult dialogue with the electorate.  They are terrified about having to explain to them that avoiding deflation means tearing up the pension promises they have made.

So the ECB marches on, creating more debt, which everyone knows can never be repaid.  Whilst pension age remains below the level set by Bismarck, 125 years ago.

It will be an interesting debate at this year’s Euromoney conference.


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