Friday, January 16, 2015

Avoiding The Black Hole Of Deflation

Switzerland pegged its franc to the euro in order to avoid deflation.  It was worried about deflation because, like Einstein's black hole, it is very difficult to escape upon entry.  It recently decided to give up on pegging the franc to the euro.  Some believe that Swiss authorities had decided that the euro was going to continue on a downward path and that the Swiss decided not to follow the euro on a downward path.  Krugman does not buy that argument.  He believes that Switzerland has become a safe haven for those who worry about the stability of their own currencies.  There is too much money flowing into Switzerland for the currency peg to work.  The inward flow of funds inflates the franc and makes Swiss exports more expensive.  The Swiss economy may contract as a result and bring with it the risk of price deflation.

The Swiss National Bank also announced that it raised the interest rate that it charges banks for holding their reserves.  This is intended to encourage banks to make loans which might stimulate the economy.  In normal times banks do not need that kind of encouragement.  This suggests that the demand for loans from creditworthy customers is not in balance with the supply of savings pouring into Swiss banks.

It would appear that governments should be doing everything that they can to avoid the deflationary trap which is so hard to escape.  Unfortunately, central banks have been more worried about the problem of price inflation which has been primary source of price instability in an expanding economy.  Moreover,  politicians have using the promise of deficit reduction to win elections.  They have convinced the public that balancing the budget is a virtue even when businesses and households are increasing their levels of savings.  When everyone increases their savings at the same time, spending shrinks along with the threats of recession and price deflation.

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