The European deflation menace
On 30 April we will know whether the Eurozone March inflation rate, which registered 0.5%, represented the low point in the trend of sliding prices observable since October. The vast majority of economists thinks so and argues that special factors, especially the late timing of Easter, can explain this exceptionally low figure.
It is also the narrative put forth by the European Central Bank (ECB), which stated in the press release following its decision not to act in March: “On the basis of current exchange rates and prevailing futures prices for energy, annual inflation is expected to pick up somewhat in April, partly related to the volatility of service prices in the months around Easter.” If this assessment proves incorrect, meaning that the inflation rate doesn’t pick up in April, then the ECB will be forced to act. Should the situation actually worsen, it might even adopt certain unconventional measures, as has been suggested lately by many of its most senior members, including President Mario Draghi.
But why should we even worry about such a scenario? When I was touring Germany in early March, many clients there were skeptical about the deflation issue. “Why should falling prices be something bad?” they asked. “Ultimately that increases the purchasing power of consumers.” Such remarks were echoed by Swiss clients, who for the past two-and-a-half years have been living with declining consumer prices without any major setback for the Swiss economy. In fact, quite the opposite has occurred: while inflation was an oxymoronic –0.2% (i.e. it was deflation) between 2011 and 2013, GDP growth registered 1.6% and the unemployment rate was 3%, making Switzerland a macroeconomic wonderland.
There are actually two types of deflation. One, exemplified by the Swiss case, can be seen as benign or even positive. The other is negative and is best represented by the Japan of the last 25 years. Deflation can originate in falling prices that stem from an increase in supply, which itself originates in technological progress and/or an increase internationally in the number of suppliers of goods and services.
Consumer price data from the 19th century UK or US show that almost half of the time those two countries faced falling prices – and not always during periods of economic crisis or depression. Indeed, both technological progress and globalizing markets caused many of those phases of falling prices.
In the second type of deflation, falling prices arise from a declining demand for goods and services. As our Chief Investment Officer Alexander Friedman writes in his latest monthly letter, “consumers defer purchases in anticipation of lower future prices and companies eschew investment due to concerns that debt levels could grow in real terms. This causes the economy to contract and leads to a debt-deflationary downward spiral, with unemployment rising and numerous negative real-world effects.”
This type of deflation is particularly worrisome for indebted countries. Between 1992 and 2013, the Japanese public debt-to-GDP ratio rose from 73% to 243%, while the inflation rate averaged 0%. A back-of-the-envelope calculation reveals that, with a 2% inflation rate over the same time period, the current ratio would fall to 163%; and with 4% inflation it would tumble to 105 %.
One can only imagine what a persistent deflationary environment would do to the European periphery, where 2013 debt-to-GDP ratios range from 93% for Spain to 173% for Greece and the current inflation rate varies from 0.3% for Italy to –1.5 % for Greece.
The scenario is certainly a deflating one.