In recent debates: following Mario Draghi’s announcement last Thursday of February’s inflation figures for the eurozone (0.8% year-on-year), fears continue to grow that the eurozone may be entering a period of deflation. Just last week, Christine Lagarde, the head of the IMF (who recently described deflation as an « ogre »), called on central bankers to be « vigilant » about deflation. Why fear what could be seen as a simple drop in prices?
At first glance, it does not seem obvious that deflation could be a dangerous phenomenon. If prices are falling, why worry?
Firstly, because when we talk about fears of « deflation, » we don’t mean a simple drop in prices; rather, we are talking about a process, a harmful economic mechanism, of which the widespread drop in prices is only a symptom. In other words, there is the ordinary definition of deflation that you will find in any dictionary (= falling prices) and the economic definition of deflation (= economic process). This difference is illustrated very well, for example, by Patrick Artus’s remark about deflation : « It would be a mistake to believe that deflation only occurs when prices fall. If we stick to its strict definition, it occurs as soon as nominal rates become decoupled from price trends. »
How, then, should this process be defined?
There is no unanimous definition, as the deflation process encompasses many elements which, when combined, block the usual economic mechanisms. At the root of all deflation is a negative shock (= a major adverse economic event).
A deflationary scenario in Europe could, for example, be envisaged as follows: growth and employment stall, consumption declines; banks restrict credit due to their difficulties (or adjustments to new prudential regulations, etc.); business investment declines due to limited credit supply, a trend toward deleveraging, and/or less optimistic outlooks; due to lower actual activity, companies lower their prices and margins decline; expectations about future economic conditions become pessimistic, companies lay off staff and/or reduce wages, investment slows significantly due to uncertainty or negative expectations; at the same time, consumers postpone purchases because prices are expected to fall; the decline in consumption is amplified by falling employment and wages; back to the beginning of the spiral (…). (We could add that falling prices increase the burden of debt, which can lead to more defaults and thus contribute to a decline in credit).
We can clearly see a negative spiral unfolding here. We can also see the key role played by one factor: expectations about the future situation, which are themselves guided by monetary, fiscal, and structural policies.
How can we break out of this process?
That’s a difficult question to answer… The difficulty of getting out of it is the basis for the immense fear of getting into it. Deflation is a « black hole that must not be fallen into, » to quote a guest on the BFM TV debate in which BSi Economics participated through V. Lequillerier (see link here). When Christine Lagarde talks about the « ogre » of deflation, it is not just to cause concern, but also to describe a reality. Breaking out of such a spiral is very difficult, as evidenced by the fact that Japan has been in deflation since the 1990s without managing to break out of it. The key to escaping it is undoubtedly to act on the very basis of this spiral: expectations. To do this, we could cite Paul Krugman (Nobel Prize winner in 2008), for example, who believes that in this scenario , « the central bank must credibly promise to be irresponsible. » You might say that this is what Japan is doing right now, after many failed attempts. Perhaps Japan’s promise to double its monetary base, which has sparked debate (some have even spoken of the risk of hyperinflation), is an « irresponsible and credible » policy that will bring inflation back.
What is certain is that if the eurozone enters deflation, it will have great difficulty getting out of it with the tools currently available to the European Central Bank. It is better to focus on ways to avoid deflation rather than ways to get out of it.
Julien Pinter
Notes
Interview with Victor Lequillerier, BSi Economics, on BFM Businesshttp://www.dailymotion.com/video/x1bdiyc_deflation-le-danger-nous-guette-t-il-dans-les-decodeurs-de-l-eco-06-02-1-5_news
Le Monde article on the recent situation in Japan: http://www.lemonde.fr/japon/article/2014/01/31/le-japon-en-passe-de-sortir-de-la-deflation_4357716_1492975.html
Paul Krugman « It’s baaack: Japan’s slump and the return of the liquidity trap » http://www.brookings.edu/~/media/projects/bpea/1998%202/1998b_bpea_krugman_dominquez_rogoff.pdf
