Deflation: Insult to Europe’s Injury

Those who say that Europe is heading for a recovery should pay close attention today. If there was a recovery under way, the European economy would be seeing some slight increase in inflation. But according to a story from, the exact opposite is true:

Ultra-low inflation in the eurozone has sparked a divide among officials and analysts over whether the risk of deflation is a real “ogre” or just a phantom menace. The head of the IMF, Christine Lagarde, warned this past week of the “rising risks” of deflation, which she called “the ogre that must be fought decisively”. “With inflation running below many central banks’ targets, we see rising risks of deflation, which could prove disastrous for the recovery,” Lagarde said.

When Lagarde talks about the detriments of deflation, she has two things in mind. First, there is the general problem that when prices are falling businesses have a disincentive to invest. Their investment costs are paid “today” while revenues recovering the cost are earned over a series of tomorrows. Under inflation the prices earned tomorrow slowly rise, increasing the margin between the fixed investment cost and cost-recovering revenue. On the other hand, under deflation future prices fall, gradually eliminating the cost-recovery margin.

This perspective on deflation is a perfectly valid concern. What is not valid is the second reason why Lagarde is worried. When prices fall over time, tax revenues fall with them. This is especially true in economies with value-added taxes, but the deflation effect on tax revenues spills over on income taxes as well. With deflation fewer workers get raises, meaning that there is much less, if any, growth in the income-tax base.

A stagnant or a shrinking tax base is not exactly what the governments of Europe’s welfare states want to have on the horizon. However, there is a very simple solution to this deflation problem: dismantle the welfare state. Reform away entitlement programs, privatize education and health care and individualize income security programs.

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Data released this past week showed that the annual inflation rate in the 18-nation eurozone dipped to 0.8 percent in December, considerably below the European Central Bank’s target of just below 2.0 percent. That masks large differences between countries, however. While average inflation came in at 2.6 percent in the Netherlands in 2013, it was just 1.0 percent in France, the eurozone’s second largest economy. In crisis-hit Greece, prices actually fell by 0.9 percent on average over 2013, according to data from EU data agency Eurostat.

The fact that Greece is suffering from deflation should end all talk about the country’s economy turning a corner. In fact, deflation is not just a problem in Greece for December 2013 – take a look at this figure, which reports Eurostat’s harmonized consumer price indices over the past three years (annual changes broken down per month):

eu DEflation

According to this index, Greece has suffered from deflation for ten months in a row. For the five last months of 2013, deflation was at one percent or more!

This is not the climate for an economic recovery. The only silver lining in this is that those who live on government handouts will probably experience a slight increase in their purchasing power. Ostensibly, those who still have a job are not seeing their money wages cut to deflation parity, which could help explain why the Greek economy seems to be reaching the trough of its depression.

At the same time, it is always important to remember that deflation also means declining per-unit revenue for businesses. Unless they can compensate with vast gains in volume of sales – an unlikely scenario in Greece today – they are not prone to invest or otherwise expand their businesses. While deflation may help bring the economic decline to an end, it will not help bring about a recovery. adds yet another aspect to deflation:

An extended period of deflation — falling prices in real terms — can encourage consumers to put off buying goods in the expectation that if they wait, they will become cheaper. That in turn weakens the economy as companies reduce output accordingly, hitting employment and demand, thereby setting off a very damaging downward spiral.

This is not a very strong effect, especially not in an economy like the Greek where consumers have lost, on average, one quarter of their standard of living during the crisis. What remains there is, in effect, an industrialized version of subsistence consumption. That said, the depressing effect on consumption as described by the EUBusiness article could very well throw a wet blanket over durable-goods consumption, which is often financed by credit. If a consumer wants a loan for a new car and the bank has good reasons to expect that new cars will actually decline in price for each new model year, then they can expect the car considered today to depreciate even faster than it otherwise would. This forces the bank to demand a very fast repayment schedule, or a prohibitively high interest rate. Either way, deflation will hold back consumption by restricting consumer credit.

In other words, Lagarde’s concerns are valid. However, as the article reports, the Eurocracy resort to the hunky-dory attitude they always take:

[For] the head of Germany’s Bundesbank, Jens Weidmann, “the risk is limited that we’ll see broad-based deflation in the euro area.” Weidmann, who also sits on the ECB board, said the eurozone was on brink of an economic recovery, which would tend to push up prices. The ECB forecasts a modest recovery in growth of 1.1 percent for the eurozone in 2014 after contracting in 2013. Weidmann’s scepticism is shared by economist Holger Schmieding at Berenberg Bank. “The widespread concerns that the eurozone could fall victim to malign deflation are overdone,” he said in a recent note to clients.

Perhaps the reason for this attitude is that deflation in the EU is at least partly caused by austerity. In the figure above, the euro-zone harmonized CPI starts its decline in late 2011, when the EU-ECB-IMF troika in a concerted effort forced austerity policies upon several euro-area economies. An admission that deflation, caused by austerity, is a problem would indirectly be an admission that austerity has not exactly helped bring about a turnaround in Europe.

Of all the economists that talked to, only one brought up this aspect:

[Countries] that have been making the biggest progress in reducing deficits have been doing that with austerity policies of cutting spending, which has also dampened prices. “What is strange is that the question is only being posed now because the European strategy is profoundly deflationist,” said Isabelle Job-Bazille, head of economic research at the French bank Credit Agricole. She warned against relying too much on medium-term inflation expectations, which have so far remained anchored near the ECB’s two percent target, as deflationary tendencies could set in by the time such expectations change.

Deflation is a likely indicator of stagnation. Its presence in the Greek economy reinforces my conclusion that the country leads Europe into the shadowy economic wasteland of industrial poverty.