Deflation for dummies: The dangers behind a complicated phenomenon

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For a couple of years now, deflation has been depicted as the coming threat facing the developed world and, more acutely, the euro area. The latter, with an annual inflation rate flirting near zero percent in August 2014, can already see this menace materializing. Although falling prices might seem economically attractive at first glance in terms of an increase in purchasing power, many dangers lurk behind this strange phenomenon.

Disease or symptom?

As it stands, deflation is not always a negative phenomenon. Prices may start falling because of the increased technological and economic performance of the supply-side of the economy, just as cell phone or computer prices have drastically dropped over the last decade for this reason. Unfortunately, the type of deflation that the euro area may be experiencing is of another type: depressed aggregate demand.

Since the European debt crisis, austerity measures have trimmed public expenditures in an unprecedented way, high unemployment and low wages have depressed private consumption, low levels of lending to European firms have put a strain on investment and a strong euro has put downward pressure on net exports. Put simply, a Keynesian professor in Macroeconomics would say that the decline in all determinants of aggregate demand, G, C, I and NX would have resulted in a shift in aggregate demand, resulting in low inflation and economic stagnation. According to this analysis, deflation or disinflation (which refers to very low inflation) appears thus more as a symptom than as the original disease, but just like a wound that is not cured, it can have disastrous snowball effects.

Falling prices and sticky wages

One first negative effect of falling prices is the subsequent rise in net wages. Since wages are rigid and do not move easily downward because of legal restrictions and monetary illusion, companies might end up laying off people or refusing to hire more employees as they become too expensive to hire. Low inflation or outright deflation therefore tends to exacerbate unemployment. In fact, it may be no coincidence that Portugal, Greece and Spain, three critical countries that are already experiencing deflation, are also among the ones with the highest levels of unemployment in the euro area (this being a prediction of the well-known Phillips Curve) [See charts below]. In turn, high unemployment leads to low levels of consumption and low aggregate demand, feeding the vicious cycle even further.

Depreciating a strong euro

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* July 2014 compared with July 2013 (Source: Eurostat)

The link between inflation and exchange rates can easily be highlighted by the theory of purchasing power parity. According to the latter, which implies several simplifying assumptions such as free movement of capital, exchange rates between two countries only reflect differences in inflation rates. Therefore, it means that if country A is facing slower inflation than country B, currency A will depreciate with respect to currency B and vice-versa. Historical data from 2009 to 2014 tend to confirm this theory to a certain extent [See charts below] and, as a consequence of the euro area’s slack inflation rate, the euro appreciated steadily with respect to the US dollar and other major currencies between 2013 and the Summer 2014.

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** February 2014 (latest datas), seasonallyadjusted (Source: Eurostat)

A too strong euro, in turn, is likely to have a negative effect on European net exports and competitiveness, depressing growth and fueling disinflation or outright deflation in the end, which would create another vicious cycle. Mr Draghi got that point, since the ECB’s decision in September 2014 to purchase asset-backed securities and slash interest rates was partially designed to break this cycle. Put simply, the rationale was that once the euro starts to depreciate, inflation in the euro area will gain momentum quasi spontaneously according to the model underlying the purchasing power parity theory.

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Source: ECB website ; www.usinflationcalculator.com
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Source: oanda.com

Sovereign debts

Deflation and low inflation also make debtors worse off since debts are issued in nominal and not in real values, increasing the opportunity cost of debt. The combination of economic stagnation and deflation can thus have the dramatic consequence of pushing the debt-to-GDP ratio of many European countries upward, reigniting the fear of another European sovereign debt crisis. This being said, 10-year sovereign bond yields for most European countries have been relatively low recently, suggesting that investors do not seem to fear this issue much. However, as everyone knows, market sentiment does sometimes change very quickly.

In the mood for deflation: the Japanese lesson

Finally, the ultimate danger lurking behind disinflation and deflation is the self-fulfilling aspect of this phenomenon known as the “deflation trap”. Basically, from the moment when deflationary expectations get firmly anchored in the mind of economic agents such that the economy gets trapped into some kind of overall deflationary mood, it becomes really difficult to get things back on track. Because of falling price expectations, consumers may want to postpone their spending such that businesses see their revenue shrink and eventually decide to cut prices among other measures, fulfilling the prediction. In the meantime, deflation might deter banks from lending to businesses for the reason cited above, this credit tightening leading to further depressed aggregate demand, which leads to more deflation.

In conclusion, deflation is a symptom with many undesirable side effects such as pronounced unemployment, harmed economic competitiveness and increased debt burden. It also involves a powerful psychological aspect that tends to be self-fulfilling. The Euro area and the European Union as a whole, given their fragmented political landscape, the rise of populist parties and the remaining scars from their two past crises, cannot afford a “Japanese-style lost decade”.

Featured picture credit: Carsten Frenzl

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