When the European Central Bank (ECB) embarked on quantitative easing in January 2015, it drove home the seriousness of deflationary concerns in Europe. There is a lingering fear that Europe could slip into long-term deflation similar to the one in Japan. The idea that increasing money supply enables an exit from deflation might hold true in the case of short-term deflation, but can we apply the same idea to long-term deflation lasting 10 to 20 years?
Arguments pointing to the risk of long-lasting economic deterioration in the United States and Europe are called the "secular stagnation" theory or the "deflationary equilibrium" theory. Although they are almost identical, there are some differences in context. In what follows, I would like to explain each theory.
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The secular stagnation theory dates back to 1938 when Alvin Hansen, then president of the American Economic Association, in his address to the association presented the hypothesis that the stagnation of the U.S. economy following the Great Depression would continue semi-permanently. In reality, the U.S. economy achieved robust growth driven by military procurement demand following the outbreak of World War II, and his hypothesis was forgotten. However, Hansen's hypothesis once again came under the spotlight as Harvard University Professor Lawrence Summers brought it up in 2013 to explain the current situations in the United States and Europe.
The ongoing arguments for secular stagnation can be classified into two types, namely, supply side and demand side.
Supply-side arguments are based on a hypothesis proposed by Northwestern University Professor Robert Gordon in 2012. Over the past 200 years, advanced economies have achieved economic growth of 2% per annum thanks to continuous technological advancement since the Industrial Revolution. Going forward, however, technological progress will stagnate and economic growth will halt as the impact of the information technology revolution is smaller than expected, according to Gordon. Some refute this argument, saying that it usually takes several decades for new critical technologies to change society, and the effects of the information technology revolution will spread out over time.
Demand-side arguments are led by Summers, who points to the possibility that chronic contractions in aggregate demand could occur even without a slowdown in technological progress. In relation to the situation of the European economy, his arguments provoked significant interest among economists, and the Centre for Economic Policy Research (CEPR) in the United Kingdom compiled and published the debate in the form of an electronic book.
In the course of this debate, Brown University Associate Professor Gauti B. Eggertsson et al. attempted to explain Summers' hypothesis with a rigorous theoretical model. In their 2014 paper, they theoretically showed that secular stagnation could set in if borrowing constraints or population decrease continues over a long period in an economy with sticky wages. They also argued that should such situation occur, the nominal interest rate would be bound to zero and deflation would continue.
However, Eggertsson et al. did not analyze the effect of a quantitative easing policy, reckoning that fiscal policy is more effective than monetary policy. In the first place, the existence of cash is left out of their model. Thus, it is incapable of analyzing quantitative easing which increases the quantity of money in the financial system.
Considering this point further leads us to question whether their model is capable of explaining long-term deflation properly. If the existence of cash is assumed, the model gives inconsistent results.
In an economy facing secular stagnation where deflation persists in a zero-interest rate environment, the value (purchasing power) of cash increases when prices fall if the quantity of cash is constant. According to their model, the elderly would give all of their cash savings to the young to purchase goods. Thus, an increase in the purchasing power of cash translates into an increase in consumption by the elderly. In other words, if the nominal quantity of cash remains constant (or increases), the purchasing power of cash would increase as deflation continues, resulting in an increase in consumption and eventually propelling the economy into a boom.
This may seem to support the effectiveness of quantitative easing but such is not the case. If it is possible for the economy to boom even when the quantity of money remains unchanged, conventional monetary policy--not quantitative easing--should be able to pull the economy out of deflation. That is, although Eggertsson et al. showed that secular stagnation can occur in their cashless economy model, introducing cash to their model eliminates that possibility.
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The deflationary equilibrium theory is an idea similar to secular stagnation. Bank of Japan (BOJ) Deputy Governor Hiroshi Nakao has been referring to it in his speeches and other recent occasions, and it seems as if the term "deflationary equilibrium" has now become the word for Japan's current economic situation. However, it is highly questionable whether economics has been able to explain real-world episodes of long-lasting deflation.
The standard model for the deflationary equilibrium theory is the one proposed by New York University Professor Jess Benhabib et al. in their 2001 and 2002 papers (introduced in my June 2013 article for this column, "On the Way to Understanding the Cause of Long-term Deflation"). The model became a standard and is treated as such by economic commentators, when Federal Reserve Bank of St. Louis President James Bullard introduced it in his paper in 2010.
Bullard insisted on the effectiveness of quantitative easing. However, it is not that he showed the effectiveness of quantitative easing theoretically, as his arguments were based on the supposition that an increase in the quantity of money would change people's inflation expectations and the experiences of the United States and the United Kingdom in 2009 through 2010.
Also in this model proposed by Benhabib et al., deflation does not occur when the quantity of money is kept constant. Long-term deflation occurs only when the quantity of money decreases. In their 2002 paper, Benhabib et al. showed that the quantity of money at equilibrium (more precisely, the sum of money and government debt) can only increase at a rate below the nominal interest rate. An economy would fall into a deflationary equilibrium when the central bank continues its zero nominal interest rate policy. However, the quantity of money would have to decrease at that time.
In this model, as in the model proposed by Eggertsson et al., the continuation of deflation in an economy where the quantity of money is constant would increase the purchasing power of money, hence resulting in an increase in consumption. A decrease in the quantity of money is prerequisite to deflationary equilibrium in which consumption declines.
Are those models capable of explaining Japan's long-lasting deflation and the current state of the European economy where fears of deflation are rising?
Japan has been in deflation for more than 15 years while the quantity of money (money supply) continues to increase. As clearly shown in the Figure, "M2+CD," one of the measures of the money supply, has increased significantly over the years. If the models were correct, Japan--where the money supply has continued to increase--should have returned to an inflationary environment. In reality, however, deflation has continued, contradictory to what the models suggest.
Conversely, what if a new model is developed to explain Japan's current situation, whereby deflation continues despite an increase in the quantity of money, and it turns out to be correct? This could amount to theoretically proving the ineffectiveness of quantitative easing.
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One big problem with the aforementioned models such as the one proposed by Benhabib et al. is the assumption that the velocity of money is constant. Money issued by central banks circulates in the economy in the form of bank deposits and the speed at which money circulates is called the "velocity of money." In an economy where the velocity of money is constant, an increase in the quantity of money supplied by the central bank would result in a proportional increase in the price level. In the standard macroeconomic model, as it stands today, the velocity of money is assumed to be constant as in the model proposed by Benhabib et al.
However, if for whatever reason the velocity of money falls in inverse proportion to the quantity of money, the economy would not be able to exit deflation no matter how many banknotes the central bank issues. As shown in the Figure, the current situation of Japan exactly matches the definition of such case.
In recent years, some attempts have been made to explain changes in the velocity of money, as seen in a 2006 paper by University of Toronto Professor Shi Shouyong et al. and a 2009 paper by University of Chicago Professor Fernando Enrique Alvarez. Building on Alvarez et al. (2009), Nao Sudo of the BOJ pointed out in his 2011 paper that a credit crunch caused a decrease in the velocity money in Japan.
If we could find out how the velocity of money responds to quantitative easing in a zero-interest rate environment, we would be able to know the effect of the policy. However, as we have yet to fully understand the mechanism, we are theoretically uncertain about the effects of quantitative easing.
Also in Europe, if the velocity of money drops in inverse proportion to the pace of quantitative easing by the ECB, deflation would set in. No optimism is warranted on the future course of the European economy.
* Translated by RIETI.
February 16, 2015 Nihon Keizai Shimbun
