Europe Embarks on Deflation

The European Central Bank is the latest to pursue a deflationary policy.

Last week, the European Central Bank (ECB) confirmed that it will stop buying fresh assets through its now €2,600,000,000,000 bond-buying scheme. This ends nearly four years of monthly purchases of government and corporate bonds by the ECB in its policy of Quantitative Easing (QE) — a policy of creating new money (i.e., inflation). QE has proven to be controversial in Europe, especially in Germany where memories of hyper-inflation (almost a hundred years hence!) still loom large. As the chart below shows, the ECB’s policy has meant that its balance sheet has expanded enormously. Back in 2007, before the financial crisis of 2008, the ECB’s balance sheet was around 13% of Eurozone Gross Domestic Product (GDP). It has now ballooned to 40% of GDP.

By stopping the purchases, the ECB has taken the first step towards the opposite policy, Quantitative Tightening (QT). Clearly, the objective is to reduce the size of its balance sheet. So if increasing the balance sheet is an inflationary policy, reducing the balance sheet must be a deflationary policy, right? Central bankers would argue that it’s not that simple of course but, in the final analysis, that is the result. Fresh money has been created. Once you stop creating it, the growth rate of fresh money creation turns negative. That’s deflation. Whether they admit to it or not, the Federal Reserve and now the ECB, are pursuing deflationary monetary policies