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Why might Europe be losing its battle against deflation?

The risk of deflation in the Eurozone is one of today’s main concerns regarding international monetary policy. The current inflation rate is now lower than 1%, well below the ECB objective of 2%. While there is some heterogeneity between Eurozone countries in terms of price index changes, virtually all of them are experiencing a similar risk of deflation, including countries with a robust economy such as Germany.

Nevertheless, why should one worry about deflation? Yielding the precise opposite effect of inflation, deflation consists of a general decrease in prices. At first it does not look like a bad phenomenon since provided that households keep the same income, they would be able to afford more goods and increase their welfare. However, in practice the price mechanism is not so simple and has further consequences. One of the main implications of a generalized fall in prices is that wages also go down which implies that the income effect of the price fall is balanced by lower earnings and hence we may not observe an increase in consumption. Moreover, any liabilities that an economic agent may have, like mortgages, will be relatively more expensive since while the nominal value of debt will not change, money loses value. Also, a general decrease in the CPI will negatively affect the value of the collateral that investors are required to present in order to receive credit from a bank, which will in turn deteriorate the lending channel leading to less investment. At a country-level the current situation is also alarmingly serious and may cause a diversity of problems, from which we select two. On one hand, economic agents constantly create expectations on price movements based on the available information of previous price dynamics in such a way that they often expect a given trend to go on and consequently make their decisions based on those expectations. In the case of deflation, by expecting prices to keep decreasing in the future, it will be optimal for agents to delay their spending on consumption/investment, since it will cost them less. However, if they adopt this particular behavior on every subsequent period the aggregate demand will keep shrinking leading to more deflation and zero economic growth. On the other hand, in real terms the amount of debt a country has to pay is higher than when prices were higher, which implies that the adjustment process, namely through taxation, becomes harder, which may hinder economic growth.

According to many economists, deflation is already a real problem in the Eurozone since labor markets in south countries currently suffer from several conditions, namely unemployment, while consumers in other Euro countries (such as Germany) are refraining from spending. Both issues translate in a contraction of aggregate demand, preventing economic growth in the area as a whole. Such an effect on demand is intensified even more when one takes into account the series of adjustments that some countries, like Portugal, have done in order to increase international competitiveness. For instance, in Portugal earnings as well as other production costs are being reduced in order to attract foreign investment while at the same time boosting exports, which may pressure prices to go down even more. Other factors that promote deflation include a bad screening process by banks when lending credit, which may lead them to incur in losses and further refrain from lending, but also demographic trends, namely  population ageing.

This is not, however, the first time the issue of deflation appears on the headlines. In fact, during the 90’s Japan face the same hazard as Europe under very similar conditions, which led to a deflationary period with dramatic consequences for its economy that culminated in a stagnation in terms of growth for almost a decade. Also in this case the efforts of the Japanese central bank were seemingly useless since there is now evidence that the country was under a liquidity trap.

Given the facts, shouldn’t the Eurozone be tackling this issue with a certain degree of seriousness? A few measures have already been undertaken by the ECB. The main method of trying to increase prices is through a monetary expansion. However, a new set of non-conventional monetary policy measures was recently launched and there is now a big discussion as to whether quantitative easing, where the ECB buys certain securities in order to increase the banks’ liquidity, will be sufficient to solve the problem of deflation. Ideally, the extra liquidity would pressure prices to go up, generating a higher level of inflation. Nevertheless, these measures are not likely to be enough as economists argue that Europe needs to put in a lot more effort since it is considered to be close to being under a liquidity trap which could lead to a potential economic disaster.

As Europe is facing a high level of depression, some economists believe we are approaching the point of no return: unsustainable unemployment, constrained demand levels and a rather fragile financial system may not be too sensitive to monetary expansions and to further non-conventional measures. Most likely, the ECB should have taken action much earlier so as to avoid the current status. Nevertheless, the risk of doing so was high at the same time signs were not so clear. So are we doomed to failure in terms of economic performance for the next years? It depends, we just have to wait and see.

 Daniel Baeta #708

Eduardo Costa #689

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Author: studentnovasbe

Master student in Nova Sbe

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