OUT OF THEIR LEAGUE

There's No Reason Why Deflation Couldn't Happen Again: Modern governments have the tools to deal with deflation. The problem is, they require the will to use them. (Clive Crook, May 19, 2003, Atlantic Monthly)

Special policies may be needed to turn the economy around when it is on the brink of deflation, and even more so once deflation has actually begun. The most effective last-resort remedy-fiscal expansion financed by money creation-is one that no policy maker would ordinarily wish to use. Also, making a success of this approach calls for close coordination of policy between the central bank on one side and the fiscal authorities (in America's case, Congress and the Treasury Department) on the other. Again, in normal times, collaboration of that sort is neither necessary nor even very desirable. Deflation therefore makes heavy demands both on policy makers' flexibility in unusual times and on their willingness to cooperate when the situation demands it.

Both have been totally absent in Japan. The finance ministry and the central bank have been sluggish to the point of paralysis in recognizing the seriousness of the country's problems and in adapting their policies to suit them. On top of that, the two institutions are fierce rivals. Not only have they failed to cooperate, they have actually conspired to undermine each other's efforts (with the central bank, for instance, responding to fiscal loosening by tightening monetary policy). You see the results.

Weighing the politics and the economics side by side, deflation gives less cause for concern at the moment in the United States than in Europe. America's economy is sluggish, to be sure, but the recent fall in the dollar is helping to prop up the country's exporters, and makes it less likely that prices will start falling. Europe's big economies are already growing a lot more slowly than America's, and there the currency markets are making things worse, not better. The euro is appreciating (partly because of Europe's relatively high interest rates). Europe's exporters are therefore coming under new pressure, and inflation will keep drifting lower.

Politics gives America an even bigger advantage. Why are Europe's interest rates so high-too high, as most of the region's economists would argue? Partly because the ECB has set itself such a demanding target for inflation: less than 2 percent, rather than, say, 2.5 percent plus or minus a margin for error. It has a stricter target for inflation than other central banks, even though Europe's current circumstances (including the imminent accession of new fast-growing members) probably call for a softer one. It chose to interpret its "price stability" mandate in this unduly rigorous way for essentially political reasons.

So far as most people are concerned, the Fed and its long-serving chairman have nothing to prove. The ECB, a freshly minted institution, sees things differently. It has no stock of credibility to run down. Its officials wanted most of all to establish impressive anti-inflation credentials from the outset, and to underline their independence from European governments. In ordinary times, those would have been worthy aims. With deflation a growing risk, such priorities are decidedly hazardous.

If prices should start falling across large parts of Europe, with all the dire consequences that would follow, what then? The close cooperation between central bank and fiscal authorities that one can imagine taking place in America in such circumstances is far harder to picture in Europe. The reason, again, is politics. Japan's problems of institutional rivalry and lack of coordination would seem as nothing: In the European Union, those same difficulties would be multiplied by the fact that 15 governments (12 in the euro area plus three outside it) would need to reach agreement with the ECB on what should be done, and then apportion the fiscal measures across the different national authorities. For this maneuvering, allow 10 years. If deflation does take root in Europe, stopping it-even though economists know how-could prove even harder than in Japan.

If there's a reason other than trying to prove that the euro is a credible currency by artificially inflating it against the dollar, that the Europeans are keeping their interest rates so high, I've not heard it. Posted by Orrin Judd at May 22, 2003 7:51 PM