Do we have to fear deflation in the Euro Area?

May be will we have to answer rapidly to this question as companies’ surveys do not show tensions on prices and because inflation rates trend lower, below the ECB inflation rate target.

A deflation period would have very negative consequences for the Euro Area. We know that when consumer price index is trending downward it implies a weakness on economic activity. One simple reason can explain this issue: it is valuable to wait to spend as in the future prices will be lower. Deflation has also some negative impacts on behavior as maintaining wage purchasing power would imply a lower nominal wage. It is a very disturbing situation that can increase households’ negative momentum by increasing uncertainty. It doesn’t also create incentives to invest for companies as demand cannot be expected to be strong immediately. It is better to wait. In other words, when deflation is not the consequence of a technological shock it produces a very negative situation, a recession or a long period of very low growth. This could lead to high unemployment rates throughout the Euro Area and probably social instability. That’s a point we have to keep in mind.

But we have to go further concerning the Euro Area. These reasons can be amplified by the high level of private and public debt.
When households’ debt is very high, negative inflation rate implies a higher real value for debt. This means that the weight of debt services in their budget constraint increases. They are not able to spend more and in fact have to reduce their expenditures.
Public debt is trending upward. Deflation would increase the public debt real value and change arbitrages in governments’ budget constraints. This will also be negative for economic activity as governments could reduce their expenditures or increase taxes to try to balance their budget.

Of course those holdings debt assets would be in a stronger position as their assets real valuation would be higher. The real rate of return increases rapidly in period of deflation. In fact we have to imagine that income distribution scheme would be forced to change dramatically in favor of those holding assets. This would create uncertainty and would deeply modify the resources allocation. This will have a impact on economic momentum.
The risk then is to converge to a deeper recession as higher real debt value will be a strong constraint on those who are indebted. It could be worse than what we have seen during this crisis.
This approach known as « debt deflation dynamic » was developed by Irving Fisher in the early 30’s and can be found here.

Euro Area households and banks have had a very specific behavior during this crisis. Households’ debt has increase since 2007 contrary to what has been seen in the USA.
The chart below takes date from the last IMF « World Economic Outlook ». Data and chart can be found on page 5 of the April 2013 edition.
What is striking is the fact that in 2012 households’ debt in the Euro Area is higher, in % of income, than in the USA. For the first three quarters of 2012, debt was 108.5% in the Euro Area versus 108.2% in the USA. But trends are very different as debt was 111.7% in the USA in 2011 versus 108.7% in the Euro Area. In 2007 figures were 138.7% in the USA and 103.1 % in the Euro Area. Deleveraging is clearly seen in the USA, not in the Euro Area. Deflation would then have a strong impact on consumers’ behavior.


The negative impact of deflation on economic activity would be enhanced in the Euro Area due to large indebtedness. This would have a very negative impact on employment even with a starting point as low as it is now.

The macroeconomic situation would be very complicated to manage and would probably asymmetric as governments and households have not the same kind of constraints and the same behavior. To try to balance its budget a government can have a levy on taxes.

But is there a real threat?

1 – Inflation rate is currently low in the Euro Area. It was 1.2% in April and is 1.4% in May. It is well below the ECB target at 2%. In Greece and in Cyprus deflation is already there. In Spain core inflation rate without the excise tax impact is already in deflation (see here on page 3. Inflation rate ex taxes was -0.6% in April) and it could rapidly be the same in Portugal. In France and in Germany, core inflation rate is below 1% and we know (since Boskin commission) that below 1% there is a doubt on whether the economy is in deflation or not.
Inflation rate is low in the Euro Area and there is already deflation in some countries

2 – There is low persistence in the inflation dynamic. Higher and lower oil price has implied rapid change in the inflation rate profile but the impact was not long lasting. When oil price increases rapidly, inflation rate is up but when oil price drops inflation drops also. There is no persistence as it could be seen in the 70’s. At this moment due to wage indexation, an oil shock pushed inflation up but inflation rate remained high due to the indexation scheme. This is very different now
This means that if commodity prices are stable with a stable contribution, inflation rate profile will depend on tensions inside the economy. If there are a lot of pressures in the economic system, on the labor market and in wage negotiations then this could imply higher inflation rate. But if it is the contrary with mild pressures, high unemployment rate, low or negative wage growth, then inflation rate could trend downward.
We can have a measure of these tensions by looking at the PMI/Markit surveys. The synthetic index is below the 50 threshold since September 2011. This means that since September 2011 economic activity in the Euro Area is below what companies have in mind as a « normal » situation. This can also be approximate by the fact that GDP quarterly change has been negative for the last 6 quarters and that unemployment rate has increased rapidly in the recent past. It is now at 12.2% an historical high.

3 – This lack of pressures comes from a weak internal demand. I have developed this point many times; austerity policy is a real explanation of this low momentum (see here). The point is that without tensions coming from demand, there are no tensions on the labor market and on wages. As far as weak internal demand is considered as the solution the risk of deflation is far from null.

4 – From another point of view, there are internal devaluations in different countries (Spain, Ireland and Portugal) in order to improve their competitiveness and at the end to rebalance their external account. Those countries where real wages increased more rapidly than productivity have now to scale their real wage on it. It creates downward pressures on wages and on prices.

In other words, economic activity is very weak in the Euro Area and is characterized by a lack of pressures from demand that cannot bring inflation rate higher. Moreover in countries where real wages are on a negative trajectory we cannot exclude that some cost competition could be seen just to improve economic activity. This could accelerate the deflation process.

As there are no tensions on oil prices, nothing will contradict the deflation process.

What we all have in mind with internal devaluation is the fact that relative prices between countries have to change in order to rebalance competitiveness inside the Euro Area. In the past, this would have come with currency devaluation but this is no longer the case. But as the process is longer with lower costs target we cannot reject a risk of deflation during the transition period.

To avoid this issue, three possibilities can change the trajectory of the economy by reinforcing internal demand.

One is to force the rebalancing within the Euro Area. It could come from an expenditure program in Germany. This would improve demand; this could also create a bit of inflation in Germany and then hasten the adjustment process in Europe. Angela Merkel sometime in the past said that taxes could go lower in Germany. But it was a long time ago now.

We can imagine that stopping austerity policies could bring higher demand reducing then the risk of deflation. Private demand is low in the Euro Area, reducing public deficit is equivalent to increase government saving. This, mechanically, reduces demand and pressures on the productive system. Last week, recommendations from the European Commission do not show an exit of this austerity strategy. The 2 year postponement is just because 2013 target was not achievable due to weak economic performance of 2011, 2012 and 2013 but it is not a change in philosophy. Forecasts for 2012 and 2013 were higher than what was observed and then budget targets could not be fulfilled.

So there is room to find to avoid deflation instead the risk is high on growth for a long time period.

The ECB has to intervene as inflation rate is too low as its target is 2%. Mario Draghi always says that the main risk in the Euro Area is on internal demand. This latter is already weak but doing nothing more than what is currently done could weaken it and favor deflation. The ECB has to use non-orthodox methods to avoid a supplementary slump in internal demand.
The ECB has to change its mind on this issue as last Thursday Mario Draghi has announced that their forecasts for 2013 was downgraded to -0.6% (from -0.5%). There will be no risks on price tensions.

If deflation is perceived as a risk by consumers this can have a strong and long lasting impact and could probably lead to new economic turbulences. That’s why it’s an important issue that cannot support the idea that the crisis is over.