Europe Needs a Credible Deflation Strategy

By Tom Cooley and Kim Schoenholtz

In the best-case scenario, avoiding deflation in Europe may be better for U.S. trade and the U.S. economy than preserving the current framework.

The great promise of the European common currency was that a single disciplined central bank could end the persistent inflationary bias in much of Europe and foster greater integration. How things have changed! The latest data show inflation in the euro area has slowed well below the European Central Bank's stated goal, and many of the economies risk a renewed contraction. Downward pressure on prices is likely to persist. It is not out of the question that the region could sink into a sustained deflation that would further cripple the economy. The ECB needs to take this threat seriously and demonstrate now that it has the policy tools (and is prepared to use them) in the event of a new deflationary shock.

Deflation is incredibly costly and dangerous. Ben Bernanke gave a speech in 2002, shortly after he became a central bank governor, called "Deflation: Making Sure 'It' Doesn't Happen Here," in which he expressed confidence that "the Fed would take whatever means necessary to prevent significant deflation." To sustain expectations of rising prices, the ECB needs to do the same.

The best strategy is to prevent deflation from getting started in the first place. But what can a central bank do if deflation has set in and the policy interest rate has sunk to zero? Bernanke cited four approaches: (1) expand the balance sheet through loans or open-market purchases of assets; (2) lower long-term yields by committing to keep short-term interest rates low or by announcing a cap on government bond yields backed by unlimited willingness to purchase securities; (3) pursue monetary expansion in cooperation with fiscal stimulus; and (4) currency devaluation.

Read the full article as published by CNBC

Tom Cooley is the Paganelli-Bull Professor of Business and International Trade and Kim Schoenholtz is a Professor of Management Practice and Director of the Center for Global Economy and Business.