January 25, 2015 / 9:36 AM / 5 years ago

Should the euro zone really fear demon deflation?

BRUSSELS (Reuters) - If the multi-billion dollar consumer electronics industry can function fine with constantly falling prices, why is deflation in the broader economy such a threat?

An employee shows fifty-euro notes in a bank in Sarajevo in this March 19, 2012 file photo. REUTERS/Dado Ruvic

Falling prices may really be more a symptom of malaise rather than a cause for further grief.

European Central Bank policymakers have repeatedly warned of the risk of being drawn into a prolonged downward price spiral, a danger that has led them to an unprecedented government bond-buying programme that will pump hundreds of billions of new euros into the sagging euro zone economy.

Inflation turned negative in the currency bloc for the first time in five years in December. But this is not yet the sustained deflation policymakers fear, and even ECB board members accept weaker oil prices should increase spending power - recognising that falling prices do not necessarily stifle consumer demand.

A prime evil of deflation, some in the ECB warn, is that consumers and companies would delay purchases and investment because they anticipate lower prices in the future.

Sure enough, Italians are cutting back on basic purchases in an environment of falling prices. But is there a causal link? Would you defer buying a car or a sofa simply because you expected it to be 1-2 percent cheaper next year?

Also, with interest rates so low, what is the incentive to save?

“Personally I think that the issue of consumption deferral is not the case, at least in the euro zone,” said Guntram Wolff, director of the Bruegel think-tank in Brussels.

However, Wolff and other economists say there are reasons for concern.

First, negative inflation means real interest rates are always positive, given lenders do not offer loans at rates below zero. This dampens investment.

Second, falling prices increase the real burden of debt, hampering, for example, Italy’s efforts to stabilise a debt-to-GDP ratio of around 130 percent.

“It’s a vicious circle that sees the real weight of debt increasing and the state cutting spending to service it. That’s the main worry of the ECB,” said ING’s chief euro zone economist, Peter Vanden Houte.

This was the debt-deflation theory of American economist Irving Fisher on the Great Depression that reckoned that any increased spending by creditors would not match spending cuts forced on debtors.

A further issue is that the euro zone needs varying levels of inflation - low in the euro zone periphery to restore competitiveness and high in countries such as Germany to let the chasing pack catch up.

Prices have fallen year-on-year for multiple months in Greece and Spain and for three of the past five months in Italy, according to Eurostat data, but German harmonised inflation is now also just 0.1 percent.


The Bank of International Settlements (BIS), in its last annual report, differentiates between “good” deflation and “bad” deflation.

In the period before World War One, deflations were generally “good”, as real GDP mostly continued to expand when prices declined.

Between the wars, the number of “bad” deflations increased, although at most times output still rose, albeit more slowly.

For the 1990-2013 period, deflation episodes were on average more like the earlier “good” kind, BIS said.

Furthermore, it said that only the Great Depression could really be referred to as a deflation spiral.

Commerzbank Chief Economist Joerg Kraemer confesses he does not see deflation as a grave problem.

“Deflation is one of the most abused terms in economic policy discussion,” he said.

Corporations can overcome mild deflation with increases in productivity, he said. For governments with debt, deflation poses a challenge, but one that is manageable with savings.

He also points to Switzerland as a country that has logically chosen deflation, by unpegging the franc from the euro and so allowing it to jump. Its central bank had previously been intervening aggressively in currency markets, boosting its liquidity and driving up real estate prices.

“They will have a longer period of negative inflation but they are ready to take the risk to avoid the longer-term risk of a real estate bubble,” Kraemer said.

Commerzbank says the euro zone’s problem is not deflation, but “zombification”, particularly ECB policy that reduces pressure on governments to carry out overdue reforms.

Demon or not, will the ECB’s quantitative easing boost prices? The euro has dropped sharply, making imported goods more expensive, and stock markets have risen. But the aggressively increasing money supply needs to enhance overall sentiment if consumer prices, not just asset prices, are to rise.

“If there’s no final demand, you can’t raise prices and there’s no inflation. The financial side is important, but the real economy has to follow to get prices rising again,” said ING’s Vanden Houte.

Editing by Susan Fenton

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