The ominous threat of deflation has haunted the Eurozone ever since the global financial crisis in 2008. Recently, fear of an uncontrollable deflationary spiral has re-emerged as prices in many of the largest European economies continue to decline. In February consumer prices in Ireland had fallen by .1% for the year, in Portugal inflation just remained positive after dropping 1.4% and in France consumer prices increased by a meagre .9% for the year. Many European Union policy making elites have called for the European Central Bank (ECB) to address the recent dip in prices. President of the Bundesbank, Jens Weidman, uncharacteristically recommended the ECB do more to stem the risk of deflation. Currently, euro rates are virtually at the zero bound, forcing the ECB to contemplate more aggressive measures, such as quantitative easing.
So why all the fuss?
Deflation is commonly regarded as the doomsday scenario by economists; once it begins it becomes almost impossible to stop. This was the case with Japan, experiencing more than two decades of a pernicious deflationary spiral, until the Bank of Japan took more aggressive action under the advice of President Shinzo Abe. In order to appreciate its danger, it is important to understand the economics of deflation.
Revered economist Irving Fisher pioneered the study of deflation with his conception of ‘debt deflation’. Fisher describes deflation as a ‘chain of events’ which includes various interrelated links. Beginning with a general equilibrium and the important factor of over-indebtedness, deflation can arise from any adverse shock to the economy. The chain of consequences may unfold as follows:
- Economic agents liquidate debt,
- Money velocity slows,
- Prices fall,
- The value of revenue and profit declines,
- Employment and output begins to slow.
The link in the chain is an ensuing wave of pessimism which causes the cycle to repeat itself. To read further see Fisher’s The Debt-Deflation Theory of Great Depressions. Fisher’s work has received various interpretations over time. An interesting take is one by London School of Economics economist Paul De Grauwe, which can also be viewed here. It’s well established that deflation increases the real value of debt, and with declining revenues, inhibiting individuals’ ability to service their debt. Paul De Grauwe explains debt deflation dynamics arise when actual inflation is lower than expected inflation at the time an individual enters into a debt contract. Therefore, the increase in the value of debt and interest (based on inflation expectations) exceeds the rise in income (based on actual inflation), forcing an individual to cut its costs or liquidate its debts.
Importantly, deflation is triggered by the collective fear of economic agents (savers, firms, banks). It is only the combined action of firms selling assets and reducing debts, banks cutting off loans and savers hoarding cash that creates a ‘self-defeating’ cycle of deflation. Paul De Grauwe expresses this cycle as a negative externality, which individuals cannot internalise as the costs of collective action are too high.
Perhaps one of the most harmful aspects of deflation is its impact on consumption. As prices begin to fall, consumers and other economic agents factor this into their inflationary expectations. If consumers believe prices will be lower in the future, they will defer consumption to a later date. This could potentially be the nail in the coffin for the Euro. Continuous drops in aggregate demand could cause the Euro to spiral into a severe deflation-induced recession. Moreover, falling prices will cause real wages to rise—providing wages remain relatively sticky in most Euro nations—leading to massive unemployment.
Is unconventional monetary policy really the solution?
Calls for the ECB to take more aggressive action to thwart the perils of deflation may be futile. The International Monetary Fund’s Christine Lagarde suggested the ECB consider quantitative easing if it wanted to prevent deflation, which threatened to derail the global recovery. However, evidence from other nations experimenting with QE, notably the US, shows a negligible impact on inflation, albeit modest positive signs in Japan.
The graph is a representation of the consumer price index and federal funds rate in the US since 1950. There are two very interesting trends that can be discerned from the graph. First, prices have been declining since the period of stagflation experienced in the 1980s. Secondly, every recession post 1980s appears to be immediately preceded by a sharp rise in the federal funds rate (recessions are represented by the grey vertical columns). Importantly, this would suggest a strong correlation between interest rates, GDP and prices. However, after the GFC in 2008 prices declined with interest rates at near 0% and continued to fall after the Federal Reserve implemented its first round of QE.
The disconnect in interest rates and economic activity in the US is also apparent in Europe. Interest rates have remained at the zero bound in the Euro for the last 5 years without any substantial rise in inflation or growth. Under these conditions, it is possible QE will only have a marginal effect on economic activity in the Eurozone.
Low inflation is a symptom of slow economic growth. It’s important for European policy makers to look beyond monetary policy and identify new policies that facilitate growth. If not, the danger of deflation will continue to hang over the Eurozone.