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THE INVESTOR
analysis
deflation
goingdown
intheworld
Despite prices remaining flat across the continent, the ECB
has consistently rejected suggestions that Europe is heading for
a prolonged period of Japanese-style deflation. But is it right?
I
nvestors have become accustomed to
worrying that inflation will erode their
returns, particularly in this era of
ultra-low interest rates. Now, however,
attention is turning to the threat of
deflation in Europe as prices are flat, or even
falling, in countries across the continent.
Deflation may not sound like a bad thing:
if the price of goods and services is falling,
surely that will encourage us to buy more,
which should be good for the economy.
Recent experience in Japan demonstrates
the fallacy of that argument, however:
deflation has been an issue for much of
the past two decades and has been a key
factor in the country’s lacklustre economic
performance.
Its GDP in 2013 was only around 10%
above where it was in 1996, while GDP in the
US, UK and the euro area more than doubled
over the same period
1
.
More pessimistic commentators have
been warning that the global financial crisis
could mean other developed countries
will follow the Japanese into a deflationary
spiral as overstretched consumers and
governments retrench sharply; these voices
have been growing louder as European
inflation has fallen.
As Reza Moghadam, director of the
European Department at the International
Monetary Fund (IMF), pointed out in a recent
blog:‘You can have too much of a good thing,
including low inflation.’
Deflation can be debilitating, particularly
if expectations of falling prices become
entrenched. If consumers or corporate
purchasers expect prices of goods and
services to be lower tomorrow than today,
they are likely to put off buying until
tomorrow – and the longer, and lower, prices
fall, the further away that tomorrow will
become.That reduces demand across the
economy, impacting on GDP and corporate
profits growth.
The IMF points out that deflation can also
have an impact on employment properties:
‘When demand drops and nominal wages
are sticky, the hit to unemployment is
cushioned by any ongoing inflation, which
effectively lowers the real wages that firms
pay.That cushion is now badly needed. Given
sticky nominal wages, near-zero inflation
in Spain is not helping to resolve the severe
unemployment problem there.’
But the biggest concern for the peripheral
countries in the eurozone is that deflation
makes it harder to deal with debt, whether at
an individual, corporate or government level.
Deflation erodes the value of income but the
value of debt, and the interest required to
service it, remains the same.A bit of inflation,
which pushes up prices and income, is much
more useful for those with large debts.
Taken as a whole, Europe is not yet
experiencing deflation but there are countries
where prices are actually falling and the fear is
that deflation will take hold elsewhere.While
the Consumer Prices Index (CPI) for the
eurozone has been falling since late 2011, it
was still 0.5% in May
1
.
Individual countries, however, are already
experiencing deflation – among them the
more troubled, and indebted countries like
Greece and Portugal, where May CPI figures
showed minus interest rates of 2% and 0.4%
respectively
1
. Even in Europe’s strongest
countries like Germany, inflation is under 1%,
and well below the European Central Bank’s
(ECB) target of 2%
2
.
‘There is a real and growing danger
that the eurozone enters a Japanese-style
bout of falling prices. But even a prolonged
period of low positive inflation would
seriously hamper the peripheral countries’
efforts to restore the public finances to
health,’ wrote Jonathan Loynes, chief
European economist at Capital Economics,
in a recent note.
The IMF has dubbed such a scenario
‘lowflation’ and warns that it‘can be
problematic for the euro area as a whole and
for financially stressed countries, where it
implies higher real debt stocks [servicing
costs] and real interest rates, less relative price
adjustment, and greater unemployment.’
By Heather Connon
