Not Deflation, but Competition and Regulation are Draghi’s biggest problems

Many financial analysts will focus on the ECB’s announcements today. Last month the FT announced: “ECB unveils radical moves to fight deflation and lift economy” and Bloomberg printed: “Draghi Unveils Historic Measures Against Deflation Threat”. Reading this one would think that deflation is the big European problem.

Deflation is not the problem. The problem is that real market interest rates are too high, due to the toxic combination of more regulation and less competition. Without a reduction in protectionism the ECB is pushing on a string.

I keep on reading that Draghi should tackle deflation. The common logic is that deflation (lower general prices) is the reason that consumers postpone consumption now. Postponing consumption would lead to a vicious cycle with even lower prices and more deflation (you all know the picture). Is this common logic correct?

No it is not. Imaging standing in the supermarket on Monday and you choose not to buy your bread because the price of the same loaf will be lower Tuesday. On Tuesday you know that the same loaf will be cheaper on Wednesday ect. In the end the person that speculates on ever decreasing prices will suffer malnutrition. Postponing consumption is only logical if you know when deflation is going to end and you can time your purchases accordingly.

The stronger conclusion is that if you would expect prices to decrease forever you could actually increase your consumption today. If we assume that we want to have a stable consumption over time and we know that we can buy fuller shopping trolleys in the future for the same amount of money,  we would increase our consumption today knowing that we can afford the same level of consumption with less money tomorrow.  We would know that we would be richer in the future and, thus can spend more today. Predictable longer-term deflation, would increase real lifetime-incomes and create a boom.

What then is the real problem with deflation? A decreasing price-level can lead to a too low real interest rate. The real interest rate is the (nominal) market interest rate minus the expected inflation.  This is the price of money now in comparison to money in the future.  If you save today you can buy more tomorrow if the market interest rate is higher than the inflation rate. If inflation is higher than the market interest rate you can buy less from your savings.

If the ECB wants to stimulate the economy, it reduces the official deposit rate in the hope/expectation that banks too will reduce the market rate for their clients (consumers and businesses) and that their clients will decide to save less and borrow more. The problem is that this market rate is still at approx. 4.5% in many European markets.

The reason for the higher market rates are threefold:

1. Lack of competition. More competition would force banks to lend at lower rates or loose business. Many banks are protected by national regulators, who insist on rules which they claim are for customer protection, but in fact are barriers for entry and favor large banks with a national coverage who have the scale to deal with the regulatory burden. Euro loans for less than 2% can already be found at Swiss banks, these banks are however not allowed to promote their products across borders.
2. More stringent capital requirements naturally reduce the amount banks will lend. In a drive to have larger buffers one has to accept that part of the buffers are filled with cash that could otherwise be lent to small businesses and individuals.
3. Lack of funding alternatives. Compared to the US, companies in the EU are heavily dependent on bank funding. US firms have tried to enter the EU market with direct lending and have had some small successes. The direct lending phenomenon is however still very small in Europe due to the high burden of regulation that these direct lending funds face in the EU.

Draghi can keep on lowering the official deposit rate and increasing the slack, without reforms that will increase the tension with significant advances, all this extra slack is doing is increasing the risk when the disastrous fall occurs.