Aim for Mild Deflation, not Mild Inflation!

January 25, 2015

Dear Mr. Draghi:

First, I want to say that I am impressed at how well you have negotiated the minefield of European economics and politics to preserve the value of the Euro. People still expect prices to go up a lot, so I think you have achieved "inflation expectation". But also, I spent all of December visiting in Germany and was amazed at how low prices are for ordinary goods compared to California (of course, gasoline prices and the Russian import ban on European food helped) even while at the same time the Euro is at a low compared to the US dollar. People are coming from the Czech Republic and Denmark to buy products in Germany! So even as inflation expectation is high, deflation is real - for the layman. Wonderful! - just amazing!

I know that the actual deflation put you under great pressure to do a "QE" and given your hesitation it seems you must have been worried about the consequences of doing that, although you now have done so. It must be hard to judge what the effect on most people would be, especially when you are not in the same financial condition as most of them, and you are being bombarded by loud and insistent voices protecting their own interests. Given the actions of the Swiss, and what that and "QE" would do to the value of the Euro vis-a-vis other currencies, you must have been tempted to tighten instead. After all, it is not clear that "QE" can avoid the malaise that afflicted the Japanese. On the other hand you would have looked very bad if you had backed away from "QE" via government bond purchases, even though you pushed responsibility for that onto the national central banks.

Because there are millions of us whose reactions affect the outcome - let me give you a data point, a layman's view of the issue and the economy - and some arguments to help you define and present an alternative.

First of all, from a layman's point of view, the postulate supporting "QE", i.e. that deflation is bad for the economy, is based on bad assumptions, and is the self-serving view of people who have a lot of non-cash assets, or debt. As a layman, lower prices for food, clothing , and shelter (and gasoline) are an unalloyed plus. Most of us could care less about the price of stock, gold, or other such financial assets since we are unlikely to have much, and if there was a crash in their prices we might even cheer. Of course, we hear in the media that that would lead to mass layoffs, so indirectly we worry about those because we "trust" our media, at least to some extent. But some of what is posited in the media about our behaviour simply does not make sense, in fact seems like outright nonsense!


The primary assumption is that people with inflationary expectations, seeing that their money will be worth less in the future than it is worth at present will accelerate expenditures. This may be true if inflation (or deflation) is bad enough, or if the person making the spending decision is an accountant. Most ordinary people are not like that. First, with a small amount of inflation or deflation (like your 2% a year inflation target) people are not going change their timetable for purchases. Most expenditures come with their own built-in timetable. You can not eat everything you need for the next month today. Festivals and holidays dont move. Education of your children follows a set timetable. It would take something like a 10% change in price over the short time horizon most people have (a few months, maybe even a few days!) before they will even consider shifting the timing of their expenditures. That works out to inflation or deflation exceeding 40% per annum, i.e. a hyperinflationary or hyperdeflationary scenario. If you dont believe these numbers, just try this experiment - postulate that there is going to be a 10% step decrease in the cost of a good on a particular date, and see how long people are willing to postpone a purchase. Then try it with a 0.1 percent step - you will find that almost nobody will bother with postponing the purchase - not even a day. Another way of stating this argument is that most people have less discretion over timing than what is commonly assumed. Additionally, inherent in this hypothesis is the fact that inflation and deflation only timeshift consumption, and do not change the overall level long term. I see that you are already saying this - "QE" only time shifts consumption, if it does anything.


Which brings us to an even bigger flaw in the postulate. Most people realize they will be unable to work when they get older, or some emergency could happen, and that they have to provide for their future. They cannot put aside the assets they want to have - food spoils, they cannot afford to buy their shelter outright, and they do not even know what they will need in the future. Tangible assets like gold are costly to liquidate when traded in small quantities. So they have to save money - cash, or promises denominated in cash. The prospect of mild inflation over a long period is going to cause them to REDUCE(!!) their expenditures (to the extent necessary to provide the additional funds they anticipate they will need when they retire). Conversely, the prospect of long term deflation will cause them to INCREASE their consumption NOW, as they will expect they will need to set aside less for that time. I think we have a prime example of this effect in the current scenario - the US economy started improving only once it became possible to think that the Fed was actually going to unwind its balance sheet expansion. Another example - Greeks, not trusting their money in the past, tended to accumulate property, so they are property rich and cash poor; while Germans are cash rich and property poor, tending to live in leased apartments rather than in owned condos, because they trusted their money and the stewards of their financial system. Taking all this further, 30 to 50 years is the time needed to carry over value earned during a person's productive years into the time he or she is living off past earnings, so this is a long term change in spending behaviour. Given that a change in value greater than 10% is meaningful, the implication is that real perceived inflation should not exceed a number like 20 to 30 basis points - i.e. 0.2-0.3 rather than 2-3 percent per annum - otherwise the compensatory reaction of the populace is going to result in behaviour that is the exact opposite of the commonly postulated behaviour, until you get to hyperinflationary (or hyperdeflationary) conditions.


We then come to the worst part of the postulate. The notion that price deflation discourages economic activity or investment is complete bunk. We have to be careful about measuring things using just one commodity (even money) - e.g. retail sales were down last year in the US - but only because the price of gasoline was low. Even if you just took gasoline sales in December - they were down 6.5% in dollar terms according to the Wall Street Journal, but the price of gasoline was down 25%, so actual consumption in gallons must have been vastly greater! Walking the malls mid-January, the modern equivalent of the miniskirt - the yoga pant - was in fashion. Instead of seeing shoppers entering with bags returning unwanted presents, I saw them looking content and leaving with small purchases. They had money left over after the Christmas season, and they spent it. An even better example is the semiconductor industry, which suffered tremendous unit price deflation between the 70s and 90s, but is one of the greatest examples of economic success and growth. The price deflation encouraged increasing unit volume to the point where total return increased so much that there was wild appreciation of stock and total economic activity.

Managing inflation means managing the exchange rate between money and other goods, and the central banker has to decide what other goods should be inflated or deflated in relative value. This is directly interfering with the signalling mechanism that makes a free market work - relative prices. Once the semiconductor industry passed its major growth phase there was a hunger to keep the party going; there was also a need to fund the US war machine. The Fed got confused about cause and effect; or used the only tool available to it, and created huge amounts of money. Before we got to saying "mild inflation is good" we tried to "sterilize" money creation that was required to preserve the stability of the financial system by forcing it into purchases of government bonds or other assets that certain parties thought were good to inflate. Unfortunately anytime the rewards for investing in any activity greatly exceed the rewards of other activities, people with money to invest are going to focus on those with the highest rewards. When the central bank purchases company stocks or government bonds, or offers effectively a put option on stock, then all investment is going to go into the creation and inflation of such securities rather than real economic activity; where the focus is on creating excuses to tap the flood of money coming from the central bank rather than tapping the return from a real economic activity. The result, blocked transmission of the money created into the general economy.

Once this got going, there was a real interest in generating reasons and arguments why "a little" inflation was good. This is why a company like Yahoo would rather purchase a startup for an outrageous sum of money and simply throw away what that startup built, than develop something in house for much less. Yes, those few founders get rich, but their investors, who own the majority of the startup, who also control Yahoo and are also few, get incredibly richer. The vast majority of people (who are not on this treadmill) get comparatively poorer and have to pay inflated prices for housing and transportation. Thus "mild inflation is good" is a meme that benefits only people who have wealth in the form of claims on non-money assets, or who have debt. The financial industry is highly creative and powerful, and will find a way to work around or bully into shape any government regulation - the only way to stop the rent seeking is to cut off the flow of funds from the central bank, forcing the financial system to invest in and profit from economic activity that benefits most people. Here is another justification for the central bank to set a goal of "mild deflation" rather than "mild inflation" - this results in discouraging the hoarding of assets other than money, and stimulates real economic activity by increasing investment in such activity, since that will have a higher return than creating stock and appreciating it exclusively via financial transactions designed to tap the flow of funds from the central bank.

If one takes the view that the economy has a certain level of growth, and the money supply is constrained to support that growth but limit inflation, then allowing elements that are not counted in the CPI (such as company stock) to inflate rapidly above that rate means that elements that ARE counted in the CPI will have to deflate. So from that narrow point of view, "sterilization" was a success. To help the broader economy, at the very least your goal of 2% inflation should also apply to "stock" inflation - it should not exceed 200 basis points over GDP growth, otherwise you are unduly favoring the interests of investors over that of consumers or savers. What we really need right now to unblock transmission is a major and lasting stock and bond market decline, that resets investors expectations of return from financial shenanigans to levels commensurate with the return from normal economic activity.


Finally, unpredictable environments, or a perception that governments are going to get greedier and/or more effective at collecting taxes, will make all people want to increase the size of their asset buffers, thus reducing spending, regardless of whether expectations are inflationary or deflationary. France showed that if you tax too much, people will even consider moving to Russia. If you give people a way to privately and safely accumulate assets, they will be more confident that the assets will be there and useful when they later need them. The ability to selectively wipe out the value of a bank deposit by freezing or seizing it (as is envisioned by anti-"money laundering" laws) plays havoc with that confidence. If you think of total activity as the real measure of a vibrant economy, then anybody with the responsibility to ensure a healthy economy needs to insure the availability (and the common use) of anonymous cash, as a means for people to resist the natural tendency of governments. They also need to ensure that it preserves its value over the long term.

So, as a layman what I would want to see you do to get me to be more free with spending, is to 1) raise interest rates to show you are serious about protecting the interests of savers and consumers and the value of the euro vis-a-vis other currencies; 2) publicly commit to "mild deflation" rather than "mild inflation" over the long term to show that you are serious about protecting the value of the euro vis-a-vis other commodities, meaning I have to save less; and 3) see you work on a political front to enhance my financial privacy, especially from government, by encouraging rather than discouraging cash transactions. Yes, there is going to be an immense howl from large asset owners and governments, but if the above arguments were being made publicly by the ECB, the spectacle in itself would improve my confidence.


It would also be interesting if you use the new powers you have obtained to supervise and regulate banks to forecast and publicly shut down a number of smaller failing banks, and then proceed onto larger ones as the public confidence in the ECB improves. What deposit protection exists should be honored with cash disbursement of the deposits to the owners, not by transferring the accounts to another bank; making the owners of the deposits suffer at least minor inconvenience until they place it back in a good bank. Large denomination notes, like EUR 1000 and EUR 5000 (even 10000) will be helpful, especially if they have the features I suggested to your colleague Benoit Coeure. The seignorage could go to the central bank of the country where the accounts are located, giving the ECB a means to redistribute funds between countries, especially towards the weakest.

... February 3, 2015

You have an opportunity with the election of Alexis Tsipras to do just that. Let Greek banks (or ones that loaned too much to Greece) go bust, but rescue smallish depositors with physical paper cash distributions managed by the Greek central bank. Actually shut down the failing banks and attach a scarlet letter to the curriculum vitae of their management. The ECB should have the authority to determine which banks to close and how much money to print to preserve confidence in the banking system and the value of the euro - and the Greek government certainly has the right to determine which depositors get rescued, which do not, how much will be rescued, and the effective date of the rescue or forfeiture. I dont know how much is on deposit with Greek banks, but I am sure it would be a significant fraction of the one trillion QE you want to get done - and most people would deposit it immediately back into a surviving bank, making them healthier. If the ECB authorizes the Greek central bank to print and distribute the money, what is leftover after distribution can be used by the Greek central bank as the cost of distribution.

A conversation with Tsipras would ensure that you have the political assistance to do it completely. From Tsipras point of view, regular people would be mildly inconvenienced, large depositors would be gored; the decision about who gets rescued and who does not would be in the hands of his Greek government, and he would have a way to fund and keep his promises if he chooses correctly.

Meanwhile you get to be the tough guy enforcing the rules for a healthy banking system. That, plus preserving the value of the euro vis-a-vis other currencies and committing to "mild" DEFLATION would keep the German electorate, and therefore Ms. Merkel, happy.

I hope this viewpoint is useful to you in developing an alternate strategy to the unsuccessful one used by Japan.

Best Wishes and good luck,



PS (I see the ECB has decided to not accept Greek bonds as collateral - game on...)

Delivered February 9, 2015