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The spectre of deflation hangs over Europe – and we should all be scared

First published: The Times, 1/11/2014

Political spectres have haunted Europe for a long time. For Karl Marx, it was communism, for Churchill fascism, and for the baby boomer generation the Soviet ‘menace’. Now we also have an economic spectre in the form of deflation. It may scare people like inflation did in the 1970s, but we should fear it for good reasons.

The term deflation is often used incorrectly to refer to phenomena that are actually quite benign. For example, oil prices have fallen since the summer from $110 per barrel to around $85-90. New technologies have cut the costs of transportation, communications and data storage and transmission. But these are relative price changes, in which some prices fall, while others rise. Deflation, on the other hand, is about a general decline in the level of prices that reflects a chronic deficiency of aggregate demand in the economy. Left unchecked, deflation has dangerous consequences and demands urgent resolution.

Falling prices make it uneconomic for companies to invest, and stymie personal consumption. Both sustain high unemployment or underemployment of both capital and labour. Deflation adds to the pressure to freeze wages or make workers redundant, aggravating the long-running stagnation or fall in real wages. Government tax revenues suffer. The monetary or nominal value of GDP stagnates or declines, pushing up the stock of debt .as a proportion. Governments tighten budgetary policies to compensate, adverse underlying economic trends are exacerbated, and countries can succumb to so-called debt deflation, that can end up in a sovereign default, financial crisis, and possibly severe political instability.

This outline of deflation describes the shocking economic and financial conditions in the 1930s, assumed widely to have been confined to the history books. And yet, most Western economies have experienced some or all of these conditions since 2011, especially in the Euro Area, and some other EU countries.

The UK has been spared the worst largely because it has its own central bank that has conducted an aggressive form of QE, it stabilised its dysfunctional banks earlier, it has a flexible currency, and it has conducted a fiscal policy, whose bark has been generally bigger than its still painful bite. Even, so UK inflation in September fell to 1.2 percent, revealing a mix of price increases and declines but confirming a downtrend that has become widespread, and sustained by the continued slump in income formation. In other words, the stagnation of money wages and salaries. So long as the economy keeps growing, and there is every prospect that it will, even if it is at a slower pace in 2015, the UK should be able to sustain ‘lowflation’ and keep deflation at arm’s length. But success is not a shoo-in, and this is a propitious time to implement different types of policies designed to keep demand in the economy from wilting over the medium-term, including a significant increase in the minimum wage, corporate tax and governance reform to encourage companies to invest, and accelerated public investment programmes financed at record low borrowing rates.

Spare a thought though for the more troublesome conditions prevailing in mainland Europe. Consumer prices in September were lower than a year ago in Greece, Italy, Spain and Portugal, and also in Poland, Hungary, Slovenia and Slovakia. In Ireland, the Netherlands, Belgium, France and Denmark, they were roughly 0.2-0.5 percent higher than a year earlier, while in Germany they were 0.8 per cent higher. For the Euro Area as a whole, the annual change was just 0.3 percent, meaning that for almost two years, the European Central Bank (ECB ) has been failing to meet its only goal, which is an inflation rate of less than but close to 2 percent. The dire state of demand and, as elsewhere, the stagnation or decay in income formation, do not look likely to change unless some sort of crisis erupts, forcing politicians to consider alternatives to the policies that have demonstrably failed to spark economic recovery. The ECB is now trying to build up its balance sheet by buying private sector assets, and allow the Euro to decline, but no real relief is likely from deflation unless it is willing to embrace open-ended QE, that is sovereign bond purchases, and preside over a substantial fall in the Euro. Legally it can do these things, and ultimately it might if conditions deteriorated enough, but it is in a political minefield. Mario Draghi seems to recognise that having Germany’s support for a limited role, compared to, say, the Bank of England, is preferable to losing it, and ending up in a more subordinate role that France and others might assert.

In a nutshell, the Euro Area has fallen victim to a destructive cocktail of economic stagnation, creeping deflation, political and economic orthodoxy, and a one-sided relationship between Germany, its principal creditor, and France and the periphery of Europe, its principal debtors. This relationship has emphasised the single-minded demand for austerity adjustment by debtors, which is taking them further away from debt sustainability and ever closer to debt default or restructuring. With no nominal growth, Italy’s debt to GDP growth has already climbed from 120 percent in 2011 to 137 percent. In Spain, Greece and Portugal, the increase has been of the order of 20-30 percent of GDP. In the absence of an urgent and radical change in economic thinking, deflation will take a stronger grip, perpetuate appallingly high unemployment, and social hopelessness, and accentuate the political fracture that favours nationalistic and anti-EU sentiment. The Balkanisation of European politics in favour of those seeking populist and poorly informed answers to complex problems is, of course, not confined to the other side of the English Channel.