Deflation: the matter under discussion

ARGUMENTA O ECO NO M ICA No 1-2(14)2003 PL ISSN 1233-5835

Magdalena Kiedrowska

P aw el M arszałek

DEFLATION: THE MATTER UNDER DISCUSSION

W c survey the ongoing d iscu ssio n concerning deflation, o u tlin in g both the theoretical and p ractical aspects o f this issue. W e form ulate six preconditions, cru cial in preventing and fig h tin g d e fla tio n , and emphasize the im p o rtan ce o f the qualitative a sp e c ts o f m onetary policy and p olicy co o rd in atio n . We find that d eflatio n can always be prevented o r overcom e.

K e y w o rd s : deflation, zero b o u n d , qualitative aspects, m o n eta ry policy, fiscal policy

INTRODUCTION

S ince the 1960s, inflation has been perceived as the main threat to m onetary stability and overall economic activity. Reducing inflation and achieving price stability has become the most im portant goal of econom ic policy in almost all countries. In recent years, how ever, another threat to price stability has emerged. B oth policymakers and theoreticians have been concerned about declining prices in the industrial and emerging m arket econom ies as well (also in Poland). After an absence of more than fifty years, the “phantom menace” of deflation enters the scene again.

T h e aim of this paper is to survey current discussion concerning deflation. W e focus our attention on tw o questions. First, w hether deflation is perceived as a real danger for the w hole global economy. S econd, how governments and central banks are supposed to avoid potential deflation or, in other words, are there any solutions available to policymakers (especially to central banks) both before and after the onset o f deflation. The latter problem is of crucial im portance for countries like Japan, Germany and (according to som e opinions) also Poland, potentially threatened by a general decline of prices.

F irst, taking into consideration a weak perception o f deflation (after som e d ecades o f persistent inflation and regarding deflation as being of m erely theoretical interest), we shed some light on definition, determinants and consequences of deflation. Second, we present opinions concerning the presence o f deflation in som e countries and the likelihood of global deflation in general. Third, we survey policy options and we notice that deflation can be

*

prevented. W e formulate six preconditions whose presence may increase the possibilities of preventing deflation. Fourth, we describe the methods of overcom ing deflation, if it has taken hold. Fifth, we conclude and draw some im plications addressing economic policy. We stress the role of qualitative aspects (credibility and transparency of anti-deflationary policy) in tackling deflation and the importance o f flexibility in central b an k ’s actions. We also em phasize the need to coordinate two main domains o f economic policy - monetary and fiscal policies.

1. DEFLATION - DEFINITION, DETERMINANTS AND CONSEQUENCES

Deflation is usually defined as a sustained decline in an aggregate measure of prices such as the Consumer Price Index (CPI) or Retail Price Index (RPI)

(Deflation. .. 2003, p. 6). It follows that deflation is a decline in the general price level of current goods and services. Then, which is important for monetary policy, such a definition does not refer to asset prices and prices o f future goods and services. Nevertheless, asset price deflation may be at tim es associated with or may even cause a decrease in the general level of price (Buiter 2003, p. 1).

Bernanke (2003, p. 1) emphasizes the use of word “general” in the given definition. As he points out, at any time, especially in a contemporary low- inflation economy, prices of some goods and services will be falling. Sector- specific price declines, although uncomfortable for producers in those sectors, generally do not cause problems for the economy as a whole and do not constitute deflation. The latter occurs only when declines of prices are so widespread that broad-based indexes register ongoing declines (this is, in fact, a very similar situation to identifying inflation). Additionally, there is a considerable difference between, for instance, a few quarters of deflation that is expected to be only temporary and a situation of prolonged, persistent deflation (Svensson 2003). It is not surprising, although worth noticing, that current definitions of deflation - and its understanding as well - differ from those formulated in times when deflation was a com m on problem, i.e. the first half of the twentieth century, when, in fact, deflation and disinflation had not been distinguished. For a survey of defining deflation in this period see Knakiewicz (1961).

Deflation, contrasted with inflation, is not price stability. But we should remember that it is not just the opposite for inflation, as is sometimes suggested (e.g. in Laidler 2001, p. 607-608) - both phenomena arise and widen in different way and have a distinct economic meaning. Additionally, instrument usage in

limiting deflation and inflation are different and also different are the difficulties which policymakers have to face in both cases. There are also numerous papers em phasizing an asymmetry of costs to deflation and inflation (see Buiter 2003, p. 5-6); B linder 2000; Reifschneider and Williams 2000).

Buiter (2003, p. 6-9) lists four specific reasons why deflation is not just inflation with the sign reversed (which will be outlined further). First, when deflation occurs, the problem of a zero bound on interest rates arises. Second, redistributions from debtors to creditors associated with unexpected high deflation in a world with imperfectly index-linked debt contracts is more destructive than redistribution from creditors to debtors during periods of high inflation. Third, due to an asymm etry in nominal wage and price adjustment, the degree of downward rigidity in some nominal prices is not matched by a sim ilar degree of upward nominal rigidity. Thus, disinflation will be more costly (i.e. the sacrifice ratio will be higher) when the inflation rate falls into a negative range than when it remains positive. Fourth, in “living m em ory”, as Buiter describes it, there has been considerable experience of inflation, while there has been only a limited experience of deflation.

The sources of deflation are well known. The most often given are sufficiently large negative demand shocks, which reduce spending so severely that producers must cut prices on an ongoing basis in order to find buyers. Such shocks may reflect a severe cyclical downturn, the bursting of an asset price bubble which started the problems of Japan, see e.g. Okina et al. (2001, p. 397-418); Aheame et al. (2002, p. 2) and Table 1 or excessively tight policy (D eflation.. .2003, p. 9). The effects of shocks may be then amplified through a further deterioration of confidence and deflationary expectations. It must be stressed that the expectations, like in the event of inflation, play the crucial role here. Krugman (2002) presents an interesting conception, how building deflation into expectations may create a self-reinforcing deflationary spiral. (According to him, deflation in Japan is “the econom y’s way of ‘trying’ to get the expected inflation it needs”).

Deflationary forces may be also transmitted across countries. This was a common fact under the Gold Standard (Knakiewicz 2001). Membership of the Gold Standard contributed negatively, imposing external constraint (fixed exchange rate) and strengthening the transmission of deflation pressures (see Table 1). Fortunately, under current circumstances, with flexible exchange rates dominance, flat money and independent policy regimes this channel of general expanding deflation is rather unlikely.

In som e cases, deflation can be caused by a positive supply shock. This can arise from a variety of factors including technological innovation and productivity growth, gains from trade liberalization or heightened expectations of long-term

political and economic stability (D eflation...2003, p. 9). A s Bemanke (2002b) supposes, China might be an exam ple of such a supply-side impulse (see also Table 2). He also notes that supply-side deflation would be associated with an economic boom, in contrast to demand-side deflation, which almost in every case brings recession. However, as Cargill and Parker (2003) suggest - while costs of demand-led-deflation are visible and huge almost immediately - initially positive supply-led deflation, sooner or later, affects the economy negatively (see deflation in the last quarter of the nineteenth century in Table 1).

But as Buiter (2003, p. 14) remarks, whatever the supply-side of the economy may generate by way of a growth o f potential output, it is always possible to use monetary and fiscal policy to also raise growth rate of nominal demand and therefore the inflation rate. Such a statement leads us to another source of deflation, namely inappropriate economic policy. Many authors e.g. Aheame et al. (2002, p. 2), Benanke (2000), Krugman (1999) indicate that Japanese deflation has been, am ong other factors to a large extent a consequence of policymakers mistakes and reluctance. This also concerns other deflation experiences, including the Great Depression as well - see Cargill (2001), Friedman and Schwartz (1963), Meltzer (1999). The critique relates to both monetary and fiscal policies (and exchange rate or structural policies). Moreover, deflation m ay arise as a result of weak coordination between individual (especially monetary and fiscal) policies. This problem will be discussed in section 3. It is worth noticing that in the past, for example in the Gold Standard, deflation had been treated as a policy instrument and, in fact, was a conscious policy choice - Knakiewicz (1961); Laidler (2001, p. 607-608). It is hardly possible that in the present policymakers have or want to unleash deflation.

In current discussion, relatively more attention has been paid than to sources of deflation to the consequences of declining prices. That is just why they have inspired animated discussion am ong policymakers, politicians and theoreticians. Deflation is not a new problem (cf. Fig. 1), thus in the context of the recent experience o f Japan and China one should assess the consequences of this process in a broader historical perspective. The lessons from the past should help policymakers to draw conclusions about the current global risk of deflation.

In the past, one could distinguish a few significant periods o f persistent deflation (compare Fig. 1 - global inflation). These were: (i) during the last quarter of the nineteenth century - especially in industrial countries; (ii) in the 1930s - the most severe deflation of the twentieth century - in the United States, Japan, Sweden and other industrialized countries (also Poland), (iii) after the Second World War - in the major economies, (iv) in the late 1980s - in Canada, Norway, Sweden and Germany, and (v) in the early 1990s - in developed countries (especially Japan).

■ A D V A N C E D ECONOMIES Sf EUROPEAN U N IO N

■ N E W LY INDUSTRIALIZED ASIAN E C O N O M IES 8 DEVELOPING C O U N TR IE S

F ig. 1 G lobal inflation (1 9 70-2004*)

S o u rce: W orld Economic O u tlo o k , IM F, April 2003

However, one could draw the most instructive lessons from the three previous periods - the last quarter of ninetieth century (for China), the Great Depression (for Japan and other developed countries), and lastly the first deflation period in Japan - which are characterized in Table 1.

H istorically (see Table 1) deflation was identified as a reduction in m oney supply that does not necessarily cause bad econom ic perform ance - e.g. see F ried m an ’s (1968) optimal quantity of money theorem . However, even if deflation was not severe, it w as widely perceived to have a negative effect on econom ic activity and w ell-being (Table 1; K um ar 2003). Now adays deflationary episodes are usually identified as periods of recession or depression. The characteristics in Table 1 confirm a variety of deflation sources already outlined: inadequate aggregate dem and, structural problems in the financial sector, rigidities in labour and product markets, large fixed nom inal debts and lastly, inappropriate policies. M oreover, the policym akers should be conscious that m ultitude and changeability in causes of deflation result in a wider range of consequences - all the m ore that the costs of deflation depend on both its sources and its extent and duration (Table 1).

T a b le 1. H istorical lessons from deflation periods -j_oo

P e rio d /ra n g e B a c k g ro u n d C auses C onsequences Precise effects

the last quarter of nineteenth century/ industrial countries

- constraints imposed by the Gold Standard in time of excess demand for gold

- technological change and population growth

- (favourable) supply shocks

- not long deflationary episodes

- not entrenched expectations of inflationary spirals

- relatively weak growth

- raising debt burdens and bankruptcies - social and political unrest

- significant volatility in output growth and frequent financial crises

- more severe inflation in the aftermath of the deflation time 1930s/ industrial countries (especially USA, Sweden and Japan) - restrictive monetary policy that resulted in a drastic decline in money supply

- transmission of deflationary pressures through the interwar gold standard d

- non-appreciation of monetary policy effects - policy errors: false assessment of collapse in prices and the large number of bank failures

- lack of activity to prevent inflationa

- drastic decline of the consumer price index (and the GDP deflator)h - significant fall in real GDP and industrial production1

- sharp increase of real interest rates

- rising real value of debt that resulted in bankruptcies and unequal distribution of income

- disruption to the bank intermediation channel and the international financial channels

- stock market crash and collapse of the banking system - rapid increase in government spending and monetization of deficits

- acceleration of inflation in the second half of the 1930s

Poland 1930- 1935

- Gold Exchange standard - underdeveloped money market

- economic crisis since 1930

- policy errors: wrong strategy of overcoming the crisis (price invariability dogma)

- crisis in Poland at least 2 years longer in comparison with other countries - significant fall in real GDP

- high unem ploym ent - pauperization o f the society - fall o f investm ent

- slower investment process

m id-1980s/Japan

- overheating of the economy

- policy m istakes during boom -bust cycle (too slow reaction o f the central bank against econom y problem s - boom -bust and dow nw ard)

- decline o f the core inflation (close to zero), followed by several quarters o f decline in the G D P deflator

- initially sharp improvem ent o f growth, coinciding with a trem endous run-up in land and equity prices - then sharp fall in these prices followed by real GDP slow ing to a crawl (declining or rising insignificant)

a Sweden and Japan were exceptions.

b During the critical period in USA (1929-33) CPI declined 24% and in Japan (1930-1931) - 30%.

c Real GDP declined in USA (1929-1933) about 29% (nominal - 46% ), in Sweden (1930-1933) - 12%, and in Japan (1930-1933) - 14%. d B. Eichengreen refers to the constraints im posed by the gold standard as the “golden fetters” .

S o u r c e : A u t h o r s ’ w o rk o n th e b a s is o f: D e f la tio n ... 2 0 0 3 , p . 1 5 - 1 7 ; C a rg ill 2 0 0 1 , p. 1 1 8 - 1 2 9 ; E b r a h im i 2 0 0 2 , p. 3 8 2 - 3 8 4 ; K n a k ie w ic z 1 9 6 7 ; K u m a r 2 0 0 3 ; W o r ld E c o n o m ic O u tlo o k 2 0 0 2 , p. 1 1 0 -1 1 1 M K IE D R O W S K A , P MA RS ZA LEK

T he lessons from the past show the main costs of deflation: a redistribution o f incom e from debtors to creditors, depressed dem and, and, potentially, a severe distortion of credit interm ediation as collateral loses value (Table 1). M oreover, price instability, connected with deflation, is likely to increase inform ation costs, interfere with market m echanism and allocation of resources, and make long term planning more d ifficult (Svensson 2003). K um ar argues additionally that while temporary deflation may not entail m ajor costs, sustained deflation is seldom benign (Should we be worried... 2003; W orld Econom ic Outlook 2003, p. 11-13). Policym akers should also be aw are that deflatio n can com e suddenly and take ro o t surprisingly quickly (th erefo re, as is proven in the case of Japan, it is v ery hard to forecast) and that unanticipated deflation involves more severe co sts in each o f the m en tio n ed aspects.

T he most damaging consequences of unanticipated deflation for the econom y is the rising real value and burden of debt (especially long term), that causes defaults and bankruptcies, and - if deflation is unexpected - the before­ m entioned (unfair) redistributions from debtors to creditors. Buiter (2003, p. 6) points out that ‘debt deflation’ (the idea first raised by Irving Fisher) was considered as an important source of financial distress (to a large extent visible in bank failures or even banking crises) by the great m onetary economists o f the nineteenth and twentieth century - cf. King (1994); Bem anke (2002, p. 2) underlines another aspect o f this issue - deflationary recession may differ in one respect from ‘normal’ inflationary recessions. T his combines with the problem (to be outlined further) that deflation of a sufficient magnitude may result in the nominal interest rate hitting the ‘zero b ound’. When nom inal interest rate has been reducing to (near) zero, the real interest rate paid by borrow ers equals the expected rate of deflation. In a period of sufficiently severe deflation, the real cost o f borrowing becom es prohibitive. Almost all types o f spending - capital investm ent, purchases o f n ew homes etc. - decline accordingly, worsening the econom ic downturn.

T he consequences of deflation also involve the asset price problem. On the one side, deflation is often listed with the threats o f asset price bubbles, and, on the other, such bubbles can coincide with deflation (Table 1). Ch. R om er suggests that the relevant lesson for today’s econom ies is that dram atic m ovem ents in asset prices can cause high levels o f uncertainty, with subsequent deleterious effects on consumer spending. The 1980s-1990s experience in Japan confirm s such a statement (E brahim 2002; Table 2). M odern theories (of asym m etric information, adverse selection, moral hazard and agency problems in financial markets) also underline the importance of the

links betw een balance sheet revaluation, access to credit and other sources of external finance, investment and consumption demand, and fluctuations in output and employment - see B uiter (2003, p. 7); G oodhart and Hoffman (2000); K ing (1994)).

Feldstein (2002, p. 3) points out the problems caused by anticipated deflation as well. Nominal wages w ould have to fall and the real rate of return on risk-less securities would be at least equal to the rate o f deflation. Securities with greater risk or less liquidity w ould have to offer higher real returns. This upward shift in the yield on the entire range of private debt and equity instrum ents would raise the cost o f capital to business, reducing investment and productivity. The problems caused by anticipated deflation are substantially worse if the sustained deflation is greater than the rate o f productivity growth and than the real rate of interest on risk-free securities (for details see Feldstein 2002). Next to these arguments C argill and Parker (2003) em phasize that deflation - even if anticipated - has the potential for additional adverse effects in the economy.

Som etim es one can consider the costs (and debatable benefits) of deflation similar to inflation costs and benefits (Buiter 2003, p. 5 -9 ). Both inflation and deflation create uncertainty about the future path of prices, an uncertainty that is harmful in itself. In some ways, m oderate deflation can b e more damaging than m oderate inflation, although m oderate inflation is m ore likely to get out of central bank control and lead to rapid inflation (Feldstein 2002). However - as has been already mentioned - som e economists underline asymmetry of inflation and deflation consequences (e.g. Svensson 2002, C argill 2001).

As has been shown in Table 1, policymakers’ m istakes may worsen the consequences of deflation. Bernholz (2003) and Buiter (2003, p. 53) consider the w rong policies even as the m ain reasons for deflationary economic perform ance in the past. Additionally, from a historical point of view in countries w here central banks understated their power to prevent deflation and/or lim ited their willingness to take unprecedented action (in worsened economic circumstances) the consequences of CPI decline w ere much severe and long-lasting.

The biggest risk (and concern) is that temporary deflation may become sustained and a self-enforcing deflationary spiral. And, since nominal interest rates cannot fall below zero, the effectiveness of conventional monetary policy (i.e. based on short-term interest rate) can be constrained - which is of particular concern when output is weakening (Should we be worried... 2003). There is a general agreement as well, that deflation w ould pose special problems within the euro area w here the combination o f relative price level

adjustm ents among countries and overall price stability (for the euro area as a whole) can cause a period o f deflation in some countries.

All these described aspects refer to measurable costs o f deflation (unanticipated and anticipated) - i.e. decrease in G D P growth, consumption, employment, money aggregates (usually M2 or M3), and an increase of the cost of living index (see also Table 1 and 2). Thus, deflation may often cause sim ilar or even more severe losses than episodes of inflation do. (This was the case in Poland, where the losses caused by deflation in the 1930s were higher than losses caused by the inflation period 1919-1923 - Knakiewicz (1967).

Convergent with Table 1 are conclusions drawn from the historical record by R ogoff et al. (Deflation... 2003, p. 15-16). They suggest that: firstly, deflation and deflationary expectations can take root surprisingly quickly; secondly, deflation can impose severe economic costs unless it reflects prim arily positive supply shocks, and finally determined and vigorous policies can m ake a critical difference to ending deflation effectively and relatively quickly.

2. DOES DEFLATION REALLY THREATEN GLOBAL ECONOMY? T aking into consideration the costs of deflation, the intensity of current discussion should not be surprising. The main questions arising in this discussion are: does deflation threaten global econom y; are the large econom ies - USA, Germany, C hina etc. - experiencing deflation and, finally, should E urope fear deflation in particular. The answers - positive or negative - will determ ine the proper activities of policymakers in the face of deflation, the m ore so because, as has been mentioned, deflation can be both costly and difficult to anticipate.

N ow adays, many econom ists state firmly that deflation is again a real danger. F or instance, Rogoff (2003, p. 8) points out that deflation arguably threatens today more countries than does very high inflation (over 40% ). M oreover, if one takes into account the well-known, u pw ard bias of the CPI - see B oskin et al. (1997); C ukierm an and Gerlach (2002); Johnson et al. (2001), and delineates deflation at 0.5% or 1.0%, deflation becom es a much larger category (see Rogoff 2003, F igure 1). R oggof s concern confirm s the IMF data that am ong the group of industrial and large econom ies, episodes of CPI decline have increased from about 1% of countries in the first half of the 1990s to over 13% during 2000-2002, while cases of deflation or inflation less than 1% have increased from 5% to over 22% (World Economic O utlook 2003, p. 12).

oo to T a b le 2 (iiv .it e c o n o m ic '- a s se s sm e n t ol d e lla lio n risk s in 2<)()>

I n d ic a to r s I S A ( ¿ t r m a m J a p a n C h in a

I’l'ICC IIV IuU c o rp o ra te prices lull iim ii.li m ore ilian c o n su m e r prices). bul e c o n o m y -w u lc a g g reg ate p ricc lev els w ith o u t signs o f d eclin in g : relativ ely siah le m ila iio n e x p ec ta tio n s

m ost fo recasters d o not c \ |x c t a sig n ific a n t ilecline in in llatio n for 2003

ilh e c o n se n su s forecasi 1.2' / )

p rices o n m ajority ol sccio rs) still h a \c faced som e d o w n w au l pressu res (o w in g lo g lo b a li/a tio n p ro cessi. n egative m ilaiio n e x p cciatio n s

second d eflatio n e p iso d e in the last four years, d eflatio n resurfaced du rin g latc-2001 e n d -2002 and started to ease o ff hy D e ce m lv i 2002 ( T l i v / \ )'' 5.5/.VO/2.5 2 4 /2 .4 /: 5 2.5/1 2/-0 S 7.5/7 S/0 I1’ A g g reg ate D em an d and the O u tp u t G ap

d o m e stic d em an d bul leted In a series ol sh o ck s, n o n elh eless co n su m p tio n is g ro w in g and w id e n in g o utput g ap (o f just o v er

2 >V< in 2(K M yi l

c o n tra c tin g real d o m estic d em an d , un em p lo y m en t rate is rising (ab o u t y'/{ in 2 0 0 ^ 1 I. Cil>P g ro w th is falling t lot the third y ear ru n n in g ) and w idening o u tp u t g a p (2 .7 5 '* )

grow ill below po ten tial, the output g ap is ex p ec te d to w iden furtliei. potentially in creasin g d o w n w ard p ressu re on prices

real ( i l ) l ’ g ro w th by S'/i in 2002 due to strong export increase

A sset Prices eq u ity m ark ets fallen sev erely sin ce p eak (in M arch 20(H)). the d e clin e in co n su m p tio n c u sh io n e d by w e ll-lim e d tax cu ts in 2001. h o w e v e r h o u seh o ld w ealth is risin g g ra d u a lh

asset m arket d e te n o ia tin g co n tin u o u sly

asset prices co n tin u e d It' d eclin e (sin c e l a i e - I W O s )

relatively goo d equity m arket perfo rm an ce:

asset p rices g o in g up

C o rp o ra te S e c to r

sh a rp fall in in dustrial o u tp u t (6(7t

d u rin g 2<M)I). the US co rp o ra te s e c to r le a d in g the eco n o m y into re c essio n iP P I fallin g sin ce 2(X )I). h ut rates o f retu rn on c ap ital still h o ld in g up

p ro d u c tio n w eak en ed c o n sid e ra b ly d u rin g 2(X)I and 2002. a n d co rp o ra te b alan ce sheet a d ju stm en ts still hav in g so m e w ay to go

record b u sin ess secloi b an k ru p tcies ex p an d in g co ntinuously M o n etary an d C redit C o n d itio n s h an k len d in g g ro u n d in g to a halt in early 2002. but not c o n tra c ted (v /y ). fin an cial .sector relativ ely h ealthy

low cred it g ro w th and w eak hank p ro fitab ility , banks s u llc n n g asset p rice d eclin es and loan l o s s e s

rapidly d e clin in g bro ad money g ro w th , b an k s stru g g lin g un d er a m o u n tain ol bad loans and rapidly d e clin in g profitability

strong foreign ex ch a n g e inflow s pushing V12 g io w th rate lo IS 5 ‘i (y /y i m 2 0 0 1 0 1 . h ead w in d s from an u n d erd ev elo p ed interbank n lark el lOW SKA , P .

Policies re m a rk a b le llc \ih iln > m re sp o n d in g lo the eco n o m ic sh o ck s, th e rea d in e ss ol the cen tra l han k lo use unorth o d o x policy m e a su re s io preveni d c lla lio n . ihe slock ol g o v ern m en t d ebt a p p ea rs lo rem ain stable

M l’ g e ared lo the e u ro .uva w here g en eral p u c e p ressu res are not d e fla tio n a ry . FP aim in g at m oving the fiscal deficit back u n d er Vi (c o n stra in e d by Stability and C irow ih Pact), the a u to m a tic s (a b ili/e rs o fferin g som e p ro tectio n ag ain st su stain ed d c lla lio n

HoJ cased M P (lo w erin g o v e rn ig h t rate to w ard i l ' floor 0 5'* by the la te - IV1« K» in su ffic ie n tly . so lai ih cic is Im lc e v id e n c e that Us a ctio n s have b een su fficiently ag g ressiv e to dent d eflatio n ary p ressu res

d esp ite im p ro v em en ts, sh o rtc o m in g s in C h in a 's in stitu tio n al fram ew o rk w hich reduce the e ffe c tiv e n ess ol indirect M P in stru m en ts, and ('lu n a laccs m ed iu m term fiscal

p i e s s u r e s E x p e n s ' o p in io n K. R ogolT cl al. M . Feldstcin IM F E c o n o m ic F o ru m

- n o sig n ific a n t iisk ol d eflatio n (h o w e v e r so m e facto rs ol d efla tio n a ry p ressu res 1

- d e lla tio n . if it ex ists, is loo lim ited to c au se p ro b lem s in e ith e r w ag es (w h ich I m e been in c re a se d ) o r interest rates

- d e sp ite the lin g erin g el'lecis ol the b u rstin g o f the equity p rice b u b b le , the risk ol d ella tio n a p p e a rs low (reflec tin g i a the a v a ila b ility o f p o licy stim u lu s)

m ild d e lla tio n is fairly likely

o fficial statistical m easu res in d ic a tes no d e fla tio n (but price in d ices o v e rstate in flatio n I

- G e rm a n ) (su ffe rin g Irom a w eak m acro eco n o m ic e n v iro n m e n t, in creasin g o utput g ap s, high u n em p lo y m en t and fin an cial sec to r strain s) laces a risk o f d eflatio n

- only m arginal signs ol d efla tio n a ry pressu res

c o n tin u o u s d e fla tio n pro b lem s

risks ol ile lla lio n in ten sify in g (from the d e m a n d sid e as well», h o w ev er risk s o f p ersisten t d ella tio n is sm all

C h in a (as well a s scv eial oihei A sian e co n o m ies) is e x |v n c n c m g serious d eflationary p ressu res

;I In 1 9 8 0 -1 9 X 9 /19 9 0 - 19 9 9 /2 0 0 0 -2 0 0 3 (IM F . W o rld E c o n o m ic ( >uilook d a ta b a s e s ) b C h i n a - H o n g K o n g : 2 .5 /1 .2/-0.X.

S o u rc e : o w n s tu d y o n th e b a sis of: D e fla tio n ... 2 0 0 3 . p. 3 X -6 I: K K o g o ll 2 0 0 3 . I a b le A l : S h o u ld >■« he w orried... 2 0 0 3 : W o rld E c o n o m ic

O u tlo o k 2 0 0 3 . p. 3 4 -3 7 00 u> l T IO N : T HE M A T TE R U N D E R D IS C U S S S IO N

The other quoted economists also try to find a reply to the above-mentioned questions. They do so relying on current studies about deflation and using four ‘standard’ sets of indicators: (1) aggregate prices, (2) m easures of excess capacity, or output gap, (3) asset markets, (4) credit m arket and monetary indicators. For each set, several variables are used to m ake the assessment more com prehensive. In addition, structural characteristic and possibilities of policy actions are taken into consideration (cf. D e flatio n ... 2003, p. 19-20). The summary of literature investigation is contained in T able 2. It must be emphasized, however, that an unam biguous assessment o f the global economy situation (and the situation of individual economies as well) is quite difficult in the face o f ever-changing and uncertain environment, and awareness of the overstatement in price indices (see the last line of Table 2). Trying to limit such problems, Rogoff et al. (Deflation... 2003, Appendix 1) have constructed a new aggregated indicator - Index o f Deflation Vulnerability - to standardize the evaluation o f deflation risk. However, even scores of this indicator are not clear.

As we can see in Table 2, there is no doubt that d eflation is a real problem in Japan, and there are countries where more or less serious deflationary pressures (C hina), risk (G erm any) or susceptibility to d eflation exist. In these countries, the characteristic causes o f deflationary p ressures have appeared - falling prices, consumption and output, rising unem ploym ent, asset prices and m oney growth volatility or decline, widening output gap, and at last overall uncertainty (Table 2). H ow ever, analysing T able 2, it seems to be dem and-led deflationary pressures in Germany, and supply-led - in China, while in the USA we can see both (demand-led and supply-led) factors. Thus the discussion about deflation threats, prevention, and o th e r ‘m edicine’ is not unfounded.

Policym akers and central bankers should also pay more attention to the risk that deflation vulnerabilities, particularly in Japan and Germany, are intensifying and can be transm itted to other regions, and ultim ately result in global deflation (repetition of the Great Depression). H ow ever, Schoenholtz

(Should we he worried... 2003) defines that risk as rem ote, considering

policym akers being alert to counter any contractionary shocks from abroad. According to IMF Report, the scope for bilateral transm ission of deflation is also lim ited (D eflation...2003, p. 1 1-12). However, a deflationary spiral in a m ajor econom y could trigger a substantial shock elsew here. Rogoff et al. (D eflation... 2003, p. 35) suggest also that the global effects of depreciation in a large country can be significant. For instance, depreciation in the US dollar surely would put a downward pressure on foreign prices (D eflatio n .. .2003, p. 35).

3. POLICY RESPONSE - PREVENTING DEFLATION

A ssessm ent of deflation risk in the large econom ies show s that deflation is an actual problem, not only a theoretical curiosity. M oreover, as Feldstein (2002, p. 4) points out, regardless of the final assessm ent of deflation risk, low inflation makes a slip into deflation clearly possible. Therefore, low inflation rates in many countries (also in Poland) make this question even m ore im portant. In this context, the question arises of what should the policymakers do to reduce the problem of deflation. First and forem ost we discuss the role o f central banks and monetary policy in tackling deflation. Nevertheless, central banks cannot do this on th eir own, so we review also the discussion concerning the other fields o f econom ic policy and consider the role of policy coordination in reducing deflationary threats.

G iven the costs of deflation one should stress the necessity to prevent the onset o f deflation (not to allow for a possibility o f deflation becom ing entrenched) and to reduce the risk of deflation appearance as well. The idea that the best way to avoid potential massive cost connected with deflation is to prevent it, is, as Bernanke (2002, p. 3) points out, nothing more than com m on sense. Problem s arise when central banks try to apply such a recommendation, especially in a low inflation environm ent. To a large degree, this is due to the already m entioned difficulties with anticipating deflation. But, as Buiter (2003, p. 53) stresses, deflation can always be prevented. O ther economists (i.e. R einhart, Kumar, Hopkins, Bernanke, Rogoff, Ch. R om er) agree with this assessm ent. Also history show s that economic policy is capable of preventing or even curing deflation (Table 1).

A s deflation (like inflation, if we assume that the fiscal theory of the price level does not hold) is ultim ately a monetary phenom enon, monetary policy plays a particularly key role in these actions. In the context of prevention, B uiter (2003, p. 13-16) considers conventional m onetary policy actions - defining them as any changes: (i) in the quantity o f base money (expansion), (ii) in the short nominal interest rate (reduction), or (iii) in the exchange rate (devaluation), all three of them , at given prices and activity levels, do not change the financial net w orth of the state (the consolidated general governm ent and central bank), now or in the future. Then, he links conventional monetary policy with a subset of the sta te ’s financial portfolio m anagem ent. This includes the sale and purchase o f long-dated governm ent debt instruments financed by matching changes in shorter-m aturity instrum ents, changes in the currency com position o f the governm ent’s financial assets and liabilities.

Planning its preventive operations, central bankers (and other policym akers) - as Rogoff et al. em phasize (Deflation... 2003, p. 31-32) - need to be attentive to four channels through which deflationary forces can be propelled and through which policy acts - closely connected to the mentioned sources o f deflation:

- exchange rate channel: an open trading system can serve as a buffer, w hile a fixed exchange rate system has, in the past, transmitted deflationary shocks;

- asset price or portfolio rebalancing channel: deflation affects the relative trade-off between assets, and cash generates a risk-free rate of return (equal to the rate of deflation), discouraging risk taking;

- expectations channel: entrenched expectations help determ ine nominal w age demands and ex ante real interest rate; once deflationary expectations set in, they help to drive up real wage co sts and real interest rates;

- credit channel: when deflation reduces the value o f collateral, banks find it difficult to discriminate credit risks, and the external finance premium rises; banks in distress may curtail lending, further driving down output and prices.

O ther researchers point at historical experiences that show other important channels, including nominal w age rigidities and distortion in credit interm ediation, through which deflation exerted adverse effects (Should we be worried... 2003). However, the classification of Rogoff et al. (and also e.g. Ahearne et al. 2002, p. 2 4 -2 4 ) em braces to some extent all the main transm ission channels.

In this context of policy effectiveness in preventing deflation, we formulate and point out six (pre)conditions to strengthen central bank (pre-emptive) actions: (1) the reasonably set inflation target (buffer against the risk of deflation), (2) proper institutional framework allowing central bank to act flexibly and unconventionally, (3) m onetary and fiscal policy coordination, (4) flexible exchange rate regime, (5) contribution of globalization and market forces and (6) sound financial system . Providing these conditions could enable the central bank to prevent deflation using conventional instrum ents.

(1) M any economists strongly advocate price stability as the best goal in conducting monetary policy, em phasizing the great progress that has been made in recent years in bringing inflation down and achieving essential price stability. However, consensus, o f how such a goal should be practically formulated, has not been reached yet. Some policymakers argue that loosely

understood price stability - like accepting a low but significant inflation rate - i.e. 4% - would be a proper solution to avoid deflation risk. The argument, often quoted in discussing m onetary policy goals, are downward nominal rigidities (see King 1999, p. 17—18; Buiter 2002, p. 35; A kerlof et al. 1996). It is assum ed that - by zero inflation targeting - they will lead to a large inefficiency in the allocation o f resources (i.e. labour). Akerlof et al. also argued that at inflation rates below 3%, the existence o f permanent trade-off m eant that unemployment w ould rise. However, according to King (1999, p. 19) these arguments are not in favour of abandoning the pursuit of price stability at all - the majority o f economists still prefer this stability, precisely defined, as a goal of m onetary policy. An exhaustive review of discussion about the best formulation o f monetary policy goal present: Blinder (2000), C argill (2001, p. 134); King (1999, p. 32-36), T ay lo r (2001, p. 4 6 -4 7 ), F ischer (1994, p. 31-40), Svensson (1999, p. 4 -1 0 ; 2000, p. 3-5), Summ ers (1999, p. 625-631), Vinals (2001, p. 113-157) and M ishkin (2000).

T he conclusion of these studies is that inflation (not price level) targeting is the best regime for monetary policy, and not only in the context of preventing deflation. Also Cargill and P arker (2003) suggest that inflation targeting has been advanced primarily as a method to prevent inflation; however it is equally useful in preventing deflation indeed. H ow ever - as it is emphasized in those studies - the target should be a specific positive inflation rate (generally betw een 2% and 3% per year). R ogoff et al. (D eflation... 2003, p. 45) list three relevant considerations: firstly, a small positive rate would reduce the likelihood that countercyclical monetary policy b ecom es constrained by the zero flo o r on nominal interest rates; secondly, the potential dispersion in trend inflation across m em bers o f a currency union m ay be large; and finally, sm all inflation may facilitate relative price and w age adjustments in an ec onom y where agents are averse to nominal w age o r price cuts. Svensson (1999, p. 36) and Summ ers (1991, p. 628) also su g g est that a small positive rate o f inflation is more likely to be a credible goal than a zero rate (see S um m ers 1991) or 4% and more (see Svensson 1999). Svensson (2003) rem arks also that it is very important that the target is sym m etric and unam biguous (and is perceived as such).

S um m ing up, central banks need to set their targets to provide a ‘b u ffer’ against the risk of deflation (and to avoid described problems). Providing a buffer zone is needed to obtain security that an unanticipated drop in aggregate dem and will not drive the econom y into deflationary territory (to lower the nom inal interest rates to zero, because measures rate o f inflation overstates the “true” rate of inflation, for the sake of the above-m entioned several bias in

standard price indexes that are difficult to eliminate in practice). As a similar solution, B linder (2000) proposes applying by the central bank a non-linear reaction function. Nonetheless, Bernanke (2002b, p. 3 - 4 ) suggests, the benefits o f a buffer zone should be weighted against the costs of higher inflation rate in normal times as well.

(2) It is often argued that in a very low inflation environm ent, when the fundam entals of the economy suddenly deteriorate, pre-emptive and aggressive actions of the central bank are required. T hat issue emphasizes a need of flexible monetary policy, which enables central banks to aim at a price stability goal in the long and m edium term, and respond to shocks in the short term (S terne and Allen 2001). Such flexibility means prom ptness with what central bank neutralize shocks (W ojtyna 1999). A dditionally, central banks admit using (and are admitted by m arkets and law) unconventional instruments in unusual situations - i.e. deflation.

The problem of a proper institutional framework refers clearly to the “rules vs. discretion” debate. In this context, a flexible m onetary policy can be seen as “constrained discretion”. As Bernanke (2003, p. 2) points out, on the one side “under constrained discretion central bank is free to do its best to stabilize output and employment in the face of short run disturbances, with the appropriate caution born of im perfect knowledge of econom y and the effects of policy” . O n the other side, Latter (2003) remembers that a too discretionary regime m ight lack credibility. By “constrained discretion” central banks must also m aintain a strong com m itm ent to keeping price stability, and, hence, expectations of inflation and deflation, firmly under control. Therefore, two issues are important. First, as R einhart argues, it is better for a central bank to make a circum stance commitment than time com mitment, because deflation pressures are difficult to foresee (Should we be worried... 2003). A similar proposal is by suggested Rossow (2002), namely “escape clauses” - owing to the forw ard-looking nature of monetary policy (especially an inflation targeting regim e) - which detail the conditions that w ould allow the central bank to m iss the target. Second, because of time lags in monetary policy, keeping inflation under control may sometimes require a central bank to anticipate and move in advance, which means to engage into “pre-emptive strike” on inflation, which may be hard to explain to the public and, in turn, induce deflationary forces (B ernanke 2003, p. 3). On the other hand, a pre­ emptive strike on deflation may be perceived as a policy m istake, leading to overheating the economy.

N evertheless, there are many econom ists supporting this quite controversial postulate o f allowing pre-emptive actions, arguing that:

- by m oving decisively and early, the central bank m ay be able to prevent the economy from slipping into deflation, with the special problems that it entails (Bernanke 2002b, p. 4); (“it would be better to make a pre­ em ptive strike against deflation that to have to try to reverse it once it’s set in” (Latter 2003, p. 32));

- one or more of above-m entioned channels could be not available - then a vigorous policy responses are required (Deflation... 2003, p. 32); - past episodes (i.e. Japan in m id -1990.) suggest that sustained deflation

can be unanticipated, even as inflation and nom inal interest rates fall close to zero (Deflation... 2003, p. 32);

- if the action of central bank is too aggressive and deflation turns into inflation, the latter can be cured by means o f conventional instruments and methods (especially when the central bank is highly anti-inflation credible), and compared with the costs of entering into deflation, the costs of excessive m onetary loosening would have been relatively lim ited (Ahearne et al. 2002, p. 4 -5 , 37);

F eldstein (2002, p. 4) suggests that such a strategy generally may be effective, yet he also considers it dangerous. L. Ball also shares this opinion. He suggests (on the basis of the Japan’s example) that sim ply pursuing fairly aggressive open-market operations and expanding the m onetary base at even 30-40% a year may be not enough to lift the econom y out of deflation. A dditionally, the impact and results of aggressive central bank actions is usually uncertain - they may turn out to be too w eak (insufficient) or too strong (rising inflation). Then, as Ball says, “if traditional policy tools are lacking, th ere’s a substantial risk that an adverse shock could lead not just to a tem porary downturn but to long stagnation” (Should we be worried... 2003). U ndoubtedly, such a risk exists; therefore, paying great attention to the fram ew ork of flexible m onetary policy - legal as well as actual - is needed.

Lots o f arguments for and against pre-emptive actions of central banks supplies discussion about central banks and asset price bubbles (see e.g. Okina et al. 2001; Bernanke 2002a; B orio and Lowe 2002) - especially as the latter could lead to deflation as Jap a n ’s experience showed (T able 1). The debaters point out the potential (positive and negative) consequences of pre-emptive actions, and the importance o f the financial sector condition (this issue is outlined in a following part). T he most controversial problem here is whether the central banks should respond to fluctuations of asset prices. In this context, we should remember that definitions of deflation (and inflation as well) do not include a decline in asset prices (see more Kiedrowska and Marszalek 2003).

(3) A heam e et al. (2002, p. 6, 37-38) point at the com bination of both fiscal and monetary loosening that would have been strongly desirable, as it would have reduced the need to rely too heavily on each instrument individually, and thus would have moderated som e o f the drawbacks associated with pushing either instrum ent too far. B uiter (2003, p. 14, 40 -4 1 ) even argues that the distinction between m onetary and fiscal policy instrum ents is an unimportant definitional issue, and that fiscal or mixed monetary and fiscal policy options will always be able to boost nominal aggregate demand. These statem ents confirm the necessity o f monetary and fiscal policy coordination - the more important by w eakening of policy instrum ents influence during deflationary economic perform ance. A potential lack of coordination will probably result in protracting deflation.

C oordination which should be understood nowadays as the process through which tw o independent authorities negotiate their strategies in order to improve results for both (M arszalek 2003), finding expression in optimal policy m ix, always succeeds in boosting aggregate dem and (and of course is beneficial to achieving other policy goals. However, the establishment of properly functioning coordination mechanism has recently been much com plicated. This is mainly due to the increasing independence of the central banks. An independent central bank may weaken relations with fiscal authorities. Problems may stem from one of three causes (o r a combination of them): (i) the fiscal and monetary authorities might have different objectives; (ii) the tw o authorities might have different opinions about the likely effects of fiscal and/or monetary policy actions on the economy (they may adhere to different econom ic theories), and (iii) the two authorities m ight make different forecasts o f the likely state o f the economy in the absence of policy interventions.

As a result, in such a situation coordination is w eak, and none of the policym akers achieve their target (B linder 1982). As A ndersen and Schneider (1986) point out, “when we have tw o independent authorities, who act in their own selfish interest, then we quite often observe a conflict over the ‘right’ policy direction. This effect should be kept in mind w hen - quite often - the argument is put forward that an independent m onetary authority should be created” . A situation where the government and the central bank do not cooperate and the consequences o f this, has been exam ined in numerous papers. A lm ost all of them show that non-cooperative behaviour leads to suboptimal states of the cconomy and increases variability o f price and output levels - e.g. Alesina and Tabellini ( l997);Bennett and L oayza (2000); Frankel (1998); N ordhaus (1994).

Potential lack of coordination will result in a suboptimal economic perform ance, so it will harm anti-deflationary policy (it was so in Japan). A dditionally, as Cargill (2001) emphasizes, central bank independence may have a constraining influence on its policy. It m anifests itself in an “independence trap” (central banks even become “prisoners” of their own independence), in which a central bank, concerned with its independence, is reluctant to implement new policies to deal with deflation and to coordinate with the fiscal authorities (cf. also Cargill and Parker (2003) where different aspects o f independence oversold are analysed). But we should not mean that the independence of central banks is an obstacle for coordination, which cannot be overcome. To im prove m acroeconomic performance, both independence and coordination are necessary (see M arszałek 2003).

(4) T he relationship of inflation performance and exchange rate regime is not unam biguous. Nonetheless, the last studies o f R einhart and Rogoff have shown that limited flexibility and freely floating currencies are characterized by best inflation performance (R ogoff 2003; Rogoff and Reinhart 2003). One must also note that a fixed exchange rate is conducive to translate changes in the real economy to downward pressures of prices - see Hong Kong example - K rugm an (2002); Latter (2003). K. Rogoff et al. (D eflation... 2003, p. 34) shows that an open trading system under flexible exchange rates contributes significantly to protection from deflation. With flexible exchange rates, and liberal trade and account regim e - while there is an incipient downward pressure on tradable good prices and interest rates (because of deficient dom estic demand) - the pressure on interest rates w ould lead to currency depreciation and aid exports. U nder such circum stances, expectations of deflation are less likely to take hold. But the risk of deflation (spreading from im ported deflationary impulses) still needs to be alert as a rule. With flexible exchange rates, the threat of an internationally transm itted, global inflationary shock is sm aller as well.

(5) T he globalization issue is equally important as it contributes to better m onetary policy performance and stimulates positive market forces. The opinion that the mutually reinforcing mix of deregulation and globalization is supporting world-wide disinflation has been more often accepted (see e.g. R ogoff 2003, p. 17-19; W agner 2001, p. 24). R ecently, globalization, deregulation and the IT revolution have given a boost to productivity growth, reducing inflationary pressures. In addition, both theory and empirics suggest that m ore competitive econom ies have more flexible nom inal prices. R ogoff’s studies (2003, p. 19-21) suggest as well that it is easier to credibly sustain low inflation (not being trapped by deflation) in a com petitive economy than in

m onopolistic one. In addition - R ogoff et al. (Deflation... 2003, p. 24) argues - globalization, lowering barriers to trade, can help in spreading the adjustment to dem and shocks. Instead of a large adjustment by a single country, a small adjustm ent globally could help to redress country-specific imbalances. In the same tim e, one should be aware that just the threat of globalization triggered off discussion about global deflation.

(6) D iscussing the issue o f preventing deflation (pre)conditions one should also encompass an aspect o f sound financial sec to r and stress the other - next to monetary policy - areas of central b ank activity, namely regulatory, supervisory and safety net, and central bank cooperation with institutions responsible for these issues (see e.g. O k in a et al. 2001, p. 4 4 6 -4 4 7 ). Thus, the central banks equipped with the possibility to act pre­ em ptively and flexibly (using indirect instruments and signalling its actions) also need properly and possibly quickly responding financial institutions. In other w ords, for the effectiveness o f central bank actio n s, a healthy, well capitalized banking system is im portant (which to a large extend can deal with liquidity disturbances and the loan losses problem ) and smoothly functioning capital markets (see also Bernanke 2002b, p. 4; Deflation... 2003, p. 32; Kiedrowska and M arszalek 2003).

To provide all the outlined conditions, an emphasis on the credibility and transparency of the central bank policy must be placed. All qualitative aspects (transparency, credibility and central bank independence) have recently become m uch more important in planning and realizing m onetary policy. Here we analyze the (often omitted) im portance of these aspects in the context of preventing deflation.

C redibility is the expectation that an announced policy will be carried out (Drazen and Masson 1994), or, as Blinder (1996, p. 11) simply puts, “m atching deeds to words”. C redibility is so crucial for a central bank, as it may be a m ean of both: (i) the time inconsistency (and inflation bias) problems reduction (the issue firstly pointed out by Kydland and Prescott (1977)), and (ii) lessening of costs of reducing inflation from unacceptable levels (see C hristiansen and Blackburn 1989). Credibility also gives the central bank greater tactical or even strategic flexibility. A credible central bank policy helps to mould inflation (or deflation) expectations to be conducive to monetary policy goals. Generally, a credible central bank will find it easier to realize its main goal - achieving price stability, which, as has been said, also includes reducing deflation.

A chieving credibility is closely connected with gaining greater transparency. The latter may be understood as the extent to which the external

presentation of the decisions corresponds with the internal decision making (F erguson 2001; Walsh 2001). T his qualitative aspect (beside contributing to greater credibility) is also crucial to achieving price stability by prom oting predictability in the behaviour of central banks, reducing uncertainty for econom ic agents and also im proving the accountability of the central bank. Therefore, during the 1990s the central banks were giv in g increased em phasis to broader and more frequent explanations of what they are doing. They have treated openness as a way to avoid misunderstandings o r confusion regarding their policy actions and as a way to gather support fo r policy initiatives - which is especially important in worse (deflationary) econom ic circum stances (see e.g. Kiedrowska 2002).

In principle, none of the form ulated pre-conditions will be effective if the central bank is not credible (this also concerns of course the policymakers). High (inflationary and deflationary) credibility in form ulating goals and conducting policy enables a central bank to act flexibly to prevent deflation (this also concerns exchange rate policy, if it lies in the central bank’s hands). For instance, Buiter (2003, p. 33) proves that the effect o f a cut in current nom inal interest rates can be leveraged through credible announcements o f future cuts in interest rates. T his will be so, because the public perceives the central bank as honest and determ ined to overcom e deflation. Therefore, it form ulates its expectations favourably to the central bank.

T he central bank also needs transparent instrum ents to act quickly (quickly influence the market expectations and actions) and properly (clearly) com m unicate with the m arkets (Kiedrowska 2003). Bernanke and G ertler (1999, p. 17-51) emphasize that transparency w ould ensure a continuity in m onetary policy (or at least o f increasing the likelihood that future policy w ould take the same general approach as recent policy has taken), and enhances the stabilizing properties of forward-looking policies (especially by explicit inflation targeting).

Both credibility and transparency are im portant to establish proper coordination between m onetary and fiscal actions, because they provide coherence of the overall m acroeconom ic program m e and are conducive to identification of policym akers’ responsibilities. Additionally, qualitative aspects positively influence m arket forces (due to transparency, a possibility o f “punish” or “reward” policym akers’ appearances and thus - to discipline them ), and create a fram ew ork to financial sector developm ent (due to the greater predictability of policym akers’ operations) (K iedrow ska and M arszałek 2002). Consequently, im proving credibility and transparency creates an environm ent more resistant to deflation.

The form ulated pre-conditions, strengthened by qualitative factors, play a crucial role in lessening the risk o f persistent deflation, and offer the central bank the possibility to be m ore effective in preventing deflation by im plem enting expansionary m onetary policy, even by using only conventional (som etim es, however, used in non-conventional way) instrum ents (i.e. open- market operations, foreign exchange swaps, standing facilities) to expand the monetary base.

Nevertheless, economists m ore and more often also look to fiscal policy (which, in short, includes any change in public spending o r tax rules; Buiter 2003) in helping monetary policy prevent deflation. Fiscal stimulating policy and additional fiscal loosening - beyond the automatic stabilizers - can play an im portant role in supporting incomes, relieving pressure on firm s’ and households’ balance sheets, and underpinning confidence (R ogoff 2003, p. 34). Sim ulations of Ahearne et al. (2002, p. 6) suggest that a moderate amount of additional fiscal loosening w ould have sufficed to prop up economic activity and keep inflation from turning negative. Such actions could be even more effective, if supported by w idely understood structural reforms that eliminate the savings-investment gap (Krugman 2002).

4. POLICY RESPONSE - CURING DEFLATION

Despite all precautions deflation still may occur, dam aging the economy. Thus, another challenge the policym akers face is how to cure deflation. First we explain the basic problem in curing deflation, i.e. liquidity trap. Its overcom ing is essential to getting the economy out of deflation, thus, the methods o f getting out of liquidity trap are simultaneously m easures to reduce deflation. W e describe those m easures and again stress the role of qualitative factors and policy coordination also in this stage of anti-deflationary action.

There is a wide range of instrum ents suggested in the literature, sometimes very unusual. Before describing them , it is worth noticing that some preventive measures as well as the pre-conditions presented above m ay also be useful as instruments of reducing the deflation problem and favourable circumstances to reverse deflation pressures. H ow ever, once deflation already appears, “classical” actions will unlikely be possible. This is a result o f the problem of “zero bound” on short-term nom inal interest rates closely connected with so- called “ liquidity trap”.

T he problem of zero bound is broadly discussed in the literature (see e. g. B uiter 2003; Goodfriend 1997, 2000; Krugman 1998a, 1998b, 1998c, and 1999; M cC allum 2000; M eltzer 1999; O rphanides and W ieland 1999; S vensson 2000, 2003; W ojtyna 2001; Wolman 1998). Yet the liquidity trap (the n am e is due to R obertson; Blaug 2000, p. 697) is not a new issue. It has been already suggested by K eynes (1936), and afterw ards, thanks to H icks and H ansen, presented form ally in the IS-LM m odel (see Snowdon et al. 1997, p. 100-114 or W ojtyna 2001). But only the recent experiences o f Japan and the United States hav e revived this problem , in the context of anti- deflationary policy and m onetary policy effectiveness. Such a perspective we adopt in our paper.

T he essence of the zero bound (and central bank instrum ents uselessness in fighting deflation) amounts to the fact that the nom inal interest rate cannot be less than zero. As Goodfriend (1997) points out, it is the consequence of the fact that no one will lend m oney at negative nom inal interest rate if cash is costless to carry over time (or, as Wolman 1998 rem arks, “no one would choose to hold assets bearing a guaranteed nom inal return when they could instead hold money, which bears a guaranteed zero nom inal return”). It may be a severe obstacle for monetary policy if it would like to stimulate the economy in ord er to overcome both deflation and recession. T he central bank can only low er its interest rates to zero, but with deflation and expectations of deflation (w hich m ight be already well anchored), the real interest rate (as it results from the F isher equation) may still be higher than the level required to “push” the econom y out of recession and to reverse the decline and expectations of further decline of prices (cf. Goodfriend 2001; Svensson 2003; Wolman 1998).

H ow ever, this is merely th e beginning of problem s for the central banks. The econom y is “caught” in a liquidity trap, w hich S vensson (1999) defines as “ a situation with zero interest rate, persistent deflation and persistent deflatio n expectations” . (O ther definitions also stress a large output gap, w hich calls for a m onetary stimulus (Should we be worried... 2003)). A cco rd in g to Svensson, in a liquidity trap m onetary policy is ineffective in the follow ing sense: a zero nom inal interest rate m eans that both nom inal bonds and money earn the sam e real rate of return. T hus, bonds and excess (h ig h er than held transaction balances) money are p erfec t substitutes and the private sector is indifferent to holding them.

T his is the biggest concern o f central banks, because in such conditions any expansionary open-market operations expanding the m onetary base have no effect on nominal and real prices and quantities. T he private sector just holds the increased monetary base instead of bonds and the real interest rates remain

unchanged. T he policy is ineffective (cannot raise the aggregate demand and thus end deflation) at least as long as there are still outstanding government bonds (used in these transactions) and as long deflationary expectations persist. T he economy is satiated with narrow liquidity. (Goodfriend 2000 expresses it explicitly; Svensson does not, although from his further consideration it also becomes clear). The problem is not only a semantic one. As King (1999) informs, there are two views of the zero bound problem. According to the first one, when interest rates are zero, households and firms have an infinitely elastic demand for money balances (this is the Keynesian case). Any increase in money supply is absorbed passively and there are no implications for broader measures of money; thus, m onetary policy is completely impotent. In the second situation, when interest rates are zero, households becom e satiated with m oney balances and any increase in money supply has an impact on broader money aggregates and causes changes in household portfolios. As King rem arks, “for there to be a liquidity trap, base money m ust be a perfect substitute for other assets”, what o f course is hardly likely. T his is the case expressed by Goodfriend and Svensson, which creates some possibilities for monetary policy, discussed in this section).

The question of how severe constraint for m onetary policy poses the problem o f zero bound, remains open. According to Ball, the liquidity trap is the main problem connected with deflation, but this opinion is not shared by other participants of discussion presented by IMF (Should be worried...

2003). S vensson (1999) lists four reasons why a liquidity trap would be undesirable. First, in the presence o f distortionary taxes in the economy, a positive interest rate (or even positive inflation) implies a positive inflation tax. This w ould allow for the reduction o f more distortionary taxes. Second, deflation, as has been already said, is not price stability. Third, probably there is no sufficient downward flexibility in nominal p rices and wages in the short and medium run to m ake deflation neutral. Fourth, the ineffectiveness of monetary policy removes all possibilities of using this policy for stabilization purpose (o f course if one believes that such a policy may be effectiv e at all). H ow ever C argill and Parker (2003) suggest that monetary policy has not become im potent, but has instead been insufficient to create an anticipation of future price increases. Thus, according to them, it is not accu rate to refer to the problem s that deflation creates for the central bank as a “ liquidity trap” . They describe the p roblem rather as a “discontinuity” in the conduct of m onetary policy.

Theoretical models, due to their constructions and assum ptions, are unable to give us an unambiguous answer. F or instance, to evaluate the influence of