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7 Reasons Why The ECB Is Wrong About Deflation (Part 1/2)


By Heiko de Boer

The ECB fears deflation. In the document “Price stability: Why is it important for you?” The ECB mentions 7 reasons why price stability as defined by the ECB, is important. I will discuss the arguments the ECB is using, in trying to convince people why prices increases of 2% on average per year are good for us. I conclude that these arguments cannot be used to reject price deflation.

Maintaining the HICP number just below 2% over the medium term is superfluous. In the long run, a change in the quantity of money supplied by the ECB, all things equal, will only be reflected in a change in the general level of prices. It will not cause permanent changes in real variables, such as real output or unemployment. The ECB policies are probably even counterproductive.


According to the ECB, price stability, as defined by the ECB, ‘makes it easier for people to identify changes in the prices of goods expressed in terms of other goods, since such changes are not concealed by fluctuations in the overall price level’.

This ECB statement is a very strange. It is the ECB’s ambition to adjust the general price level. The reason for ´fluctuations in the overall price level’ are monetary policies of the ECB. Without monetary policies, changing prices and especially changing relative prices are due to ever changing consumer preferences and changing supply conditions. In a free market, without the ECB interfering, there would not be a thing as ‘prices fluctuating overall’. In absence of a central bank increasing the money supply, prices would probably go down on average. But, once prices have the tendency of going down, the ECB will step in, aiming to increase the overall price level. Therefore, price developments are actually concealed by the monetary policies of the ECB. The sentence should read the other way around:

‘Price stability, aimed for by the ECB and their monetary policies, makes it more difficult for people to identify changes in the prices of goods expressed in terms of other goods, since such changes are concealed by fluctuations in the overall price level’.

The ECB aims to change the overall price level. It is not possible for all prices going up by the same amount, the ECB acknowledges. Prices of some goods will be affected to a larger extend due to the ECB monetary policies. Other prices less. The result is that it is more difficult for people to identify changes in the prices of goods: did the price of a certain good go up due to an increase in demand for this good or due to monetary policy? In addition to ever existing market uncertainties, there is now also uncertainty due to monetary policies.

Also interesting is the ECB reason why price stability defined as prices increasing somewhat less than 2%, is better than prices declining by 2%? The ECB has a clear preference for positive price inflation:

In the case of general deflation, consumers may not be aware of the fact that a fall in the price level of a single product merely reflects general price developments and not a fall in the relative price level of this good. As a result, they may mistakenly buy too much of this product.

Why does this unawareness of customers only exist in the case of prices falling? Would the following sentence not be equally true?

In the case of general inflation, consumers may not be aware of the fact that an increase in the price level of a single product merely reflects general price developments and not an increase in the relative price level of this good. As a result, they may mistakenly buy too little of this product.

The ECB concludes that in case of price stability, where on average prices are going up somewhat less than 2%, firms and consumers do not run the risk of misinterpreting changes in the general price level and make better informed consumption and investment decisions. Our conclusion is the other way around: In case of an environment of ´price stability´, realised by ECB policies of growing the money supply and keeping interest rates artificially low, firms and consumers run the risk of misinterpreting changes in the general price level. This is causing mal- investments and sub optimal consumption decisions.

Doing nothing and accepting price deflation would be a much better strategy.


The ECB believes that ‘if creditors can be sure that prices will remain stable in the future, they will not demand an extra return premium, to compensate them for the inflation risks associated with holding nominal assets over the longer term. By reducing such risk premia, thereby bringing about lower nominal interest rates, price stability contributes to the efficiency with which the capital markets allocate resources and therefore increases the incentives to invest. This again fosters job creation and, more generally, economic welfare.’

Lower nominal interest rates do not improve the efficiency with which capital markets allocate resources. If interest rates are naturally low, people’s time preference is low. This means that people have a higher preference to consume in the future. Money will be made available for investors, to invest in the production structure. Entrepreneurs will compete for this money and make sure capital gets allocated efficiently. Efficient allocation means that the investments are tuned towards people´s time preference. If interest rates are high, people’s time preference is high. This means that people have a higher preference to consume now instead in the future. High interest rate therefore are an indication of high current consumption demand.

Efficient allocation also means that high risk ventures require a higher return. There is nothing wrong with risky ventures. The risk premium of such ventures is just higher. This is entirely efficient. Reducing risk premia does nothing for allocating capital more efficiently.

By lowering the nominal interest rates, the ECB price stability policy actually contributes to inefficiencies, causing mal-investments. This deteriorates the job creation process and, more generally, hurts economic welfare.

Also, this point is not an argument against accepting price deflation. The ECB mentions that it is the inflation risk that results in higher risk premia. By accepting price deflation, the ECB would have a good strategy to avoid inflation risks.


The ECB believes a ‘credible maintenance of price stability also makes it less likely that individuals and firms will divert resources from productive uses in order to protect themselves (i.e. to “hedge”) against inflation or deflation, for example by indexing nominal contracts to price developments. As full indexation is not possible or is too costly, in a high-inflation environment there is an incentive to stockpile real goods, since in such circumstances they retain their value better than money or certain financial assets. However, an excessive stockpiling of goods is clearly not an efficient investment decision and hinders economic and real income growth.‘

The ECB talks about hedging and stockpiling. Investors can hedge themselves against unexpected inflation. For someone to be hedging and ‘buying inflation’, logically someone else must be selling. You can never hedge on your own. All activities of buying and selling in a market contribute to the efficiency of a market. Investors do not always agree on future price developments. Or investors have opposing positions enabling them to exchange their inflation exposures. A producer of goods, such a grain or maize for instance, may prefer to hedge his risks by locking in certain future prices. Such hedging policies do not divert resources from productive uses. Such policies may actually support the productively investing of resources, because the producer is now more certain about future possible profits. The market functions in such a way that the producer will find another counterparty to exchange the future price position with.

The ECB talks about hyperinflation and the negative consequences. According to me, hyperinflations are caused by supply shocks, such as earthquakes or wars, possibly in combination with money printing policies. The ECB however cannot prevent or solve supply shocks. No more products or food will be made created if more money is available. The ECB can only implement monetary policies in an attempt to mitigate the risks. In the case of rising prices, the ECB could reduce the money supply, in an attempt to reduce prices. However, central banks never lower the money supply. That is not why they exist. A policy that accepts deflation may be the best strategy to prevent hyperinflation.

If there is high inflation, the ECB says, there is an incentive to stockpile real goods: ‘However, an excessive stockpiling of goods is clearly not an efficient investment decision and hinders economic and real income growth’. I would like to note that this ECB reason assumes price inflation and therefore cannot be an argument against price deflation.

If producers expect the prices of their goods to rise more than the ‘average’, for instance due to more demand, they will invest in expanding the supply of their own goods. This way the producer can make money, by benefitting from the difference between the future price and the current price. This price differential is the ‘interest’ that can be generated by the investment. This investment is a good allocation of resources. This reasoning applies similarly to a price deflation environment. If a producer expects the price of his goods to decline by 10%, he/she will not invest if his costs do not go down by more. These decisions are illustration of a good allocation of resources and of capitalistic saving: the accumulation of goods designed for an improvement of production processes.

If there is high inflation, people will feel an incentive to stockpile goods such a gold or in extreme circumstances food. Stockpiling is another word for plain saving. The aim of plain saving is later consumption. If the future is expected not to differ from the present, there is no reason to engage in plain saving. Stockpiling will only occur if people expect a dramatic change or are getting extremely nervous about the future. Stockpiling of goods can in that case be an efficient and rational decision.

If the owner of a certain product (say grain) expects the price to go up dramatically, for instance due to an expected crop failure, it is prudent to stockpile food in order not to die from starvation in the future. If the owner expects future prices to be high, he expects people will have a high demand for this product in the future. If the owner is wrong, he has made a wrong ‘investment decision’. If the owner is right, consumers will be willing to offer more other goods and services in exchange for grain in the future. These consumers will be happy. And the owner will be rewarded for his skillful decision.

If someone else shares the expectations of rising prices, and it is possible to invest in such a venture, this someone else probably will do so. This other person may sell other goods that are less in demand (for instance money), use the proceeds to invest in producing these goods and reap the benefits by the expected higher future prices. This way, economic growth has been generated. So, entrepreneurs and investors do respond to changing price developments and market opportunities.

If is not possible to invest in such a venture, because there are restrictions on land or if there is just 1 supplier of a certain good, then there is cause for concern. In that case a monopoly position is being abused. That would be a completely different story. Restrictions such as a monopoly of any kind hinder economic growth. Maybe this also applies to monopolies on issuing money.