Deflation: a coming problem

Corentin Corcelette, translated by Marie Donnet
21 Janvier 2015

The new fear of European countries is called deflation. In Europe, austerity policies have led to an economic slowdown and are the main cause of this deflationary risk. In popular imagination, deflation is a decline in price level and implicates a recovery of the purchasing power. Reality is radically different: the deflation’s vicious circle is not at all desirable.

crédit DR
crédit DR
The first objective of the European Central Bank (ECB) is to maintain inflation at 2% per year. However, for the month of August 2014, the euro area’s annual rise in prices  (between August 2013 and 2014) has only reached 0.3%. In France, this figure came to 0.5%, but prices have begun to fall in Greece, Spain, Portugal, and Slovakia. To be more precise, economists talk about deflation when the price reduction is not accompanied by a corresponding drop in interest rates. It is for example, the case when prices decrease and interest rates cannot become negative. To understand this definition we will look closer at deflation’s different impacts.

Deflation’s vicious circle

Two situations need to be distinguished: short and long-term. In the short-term, deflation does not cause any major problems. On the contrary, it contributes to a purchasing power’s recovery. Indeed, there is the example of salaries in the private sector in France that increased by 1.5% between March 2013 and 2014, whereas inflation only increased by 0.6%. Nevertheless-to-say, in the long-term, deflation is a disaster for the economy as households postpone their shopping to anticipate a fall in prices. Indeed, why would they buy today when prices will be even less expensive tomorrow? Therefore, companies will put this decrease in consumption on the cost of goods and will have to cut their margin by possibly adjusting their payroll, which means they will have to dismiss employees. These two effects are easily understandable. Let’s now come back to the deflation’s definition mentioned above. 

Deflation is characterized by an increase of real interest rates. The latter define what economists called the cost of capital. This argument is comprehensible with a simple example. If we take out a €100 lending with a 2% interest rate.  Next year I will have to repay €102. If in the meantime prices fall by 2%, then my property worth €98 and if I decide to sell it to repay my loan, the real interest rate will reach 4%, because it lost its value. In fact, it comes to 4%. Let’s take the opposite example. If instead prices have increased by 2%, then my property will worth €102 and the real interest rate will be 0%. In some cases inflation can be desirable. It means that during deflationary period an investment project needs to be more profitable to be ‘justified’. The decline in the level of investment caused by the increase of real interest rates is another characteristic of deflation.

The vicious circle does not stop there. In addition to what was said before, deflation will indeed lead to a rise in indebtedness. The interest rates of the government debt’s repayment go up. This way, it is more difficult to reduce its debts, while government debt already represented 94% of France’s GDP, 97% in Spain, 136% in Italy in the first half of 2014. Let’s take another example to understand better. If a State suffers from a national debt reaching 90% of its GDP, from a 3% government deficit, from 2.5% inflation and only 2% growth, then the 93% government deficit will represent 104.5 GDP points the following year. In the end, it will lead to a 1.5% indebtedness rate’s reduction, which will reach 88.5%, but if another State, like France, has a 0.5% growth and inflation, the 93% national deficit will then represent 101 GDP points. Thus there will be an increase of the indebtedness rate from 2 to 92%.

Deflation’s causes

The first thing to notice is that this problem seems to be internal to the euro area. Even if the slowdown of the Chinese economy causes a fall in exports toward this country, the United States is the one at the origin of this crisis due to hazardous financial deregulation and high social imbalances. The country manages it much better and this year it benefits from 10 more GDP points than before the crisis and 1.2 additional million jobs were created. While Europe experiences an inferior output level when in 2008, 4.8 million jobs were suppressed. The problem would be the euro area’s homogeneity. Indeed, its external surpluses show an excess of savings.

Those external surpluses are almost exclusively German. With its declining population, Germany has no other choice than imposing a budgetary discipline to the rest of Europe. This way across the Rhine, the Maurice Allais economy Nobel price does not really echo as it says “it is not because one is really indebted that one cannot take out a loan when it comes to financing a highly profitable project”. For example, investing in the energy transition could be very lucrative; however the German population decreases too quickly with a birth rate at 1.4 children per woman. In this case, the national debt’s reduction and the government accounts’ restoration are essential for a country that is aware it would produce less in the future due to its declining population.  

As opposed to Germany, whose population is currently 25 million higher, France will be the most populated European country in 30 years, which is why the latter is not necessarily or urgently need to update government accounts.

This way with its recessive impact, austerity worsens things. In 2009, States let deficit go to avoid a collapse of the activity like in 1929. Today it is not the case. Southern countries’ austerity plans pile up, which provokes as seen previously a limited result on deficits due to the economy’s stagnation: tax revenues are lower. For example, government deficit still comes to 12.7% in Greece and to 7.1 % in Spain. Moreover, the euro area’s national debt represents on average 96.4% of the GDP and an increase by 320 billion is expected this year. The race to the lowest pay policy is an example of this policy, which aims at restoring external accounts by attracting investors. 

Since the beginning of the crisis one can hear in France that the problem is the competitiveness and thus apparently the extremely high labour costs. This article will not deal with this subject, but it is the policy implemented in the euro area. This way a worker’s cost has decreased by 15% between 2010 and 2013 in Greece, by 3% in Italy, 3.3% in Portugal, 4% in Spain and 4.9% in Ireland. Nevertheless, as this measure is conducted simultaneously by all members, it is not efficient. The competitive advantage has been limited except for France. As a matter of fact, France’s competitiveness declines compared to Spain, a very important partner, and its specialization does not allow the country to export outside the euro area, contrary to a country such as Germany. The other problem of this policy is the domestic demand’s reduction, because labour costs must also be interpreted in terms of incomes, which is to say in terms of consumption. While the growth of a country like France is mainly based on consumption, the latter is contracted.

Solutions to get out of deflation

Not to be in the case of Japan, it is important to avoid a worsening of the situation. In 2013, government debts came to 250% of Japan’s GDP, but they were mainly held by Japanese, which is why the country is not attacked by markets. Between 1997 and 2013, its GDP at current prices decreased by 10%. For 20 years deflation is common practice in the country. After analysis, coming out of deflation seems to be difficult to overcome. In Europe several mechanisms are implemented to avoid the inflation spiral. The refinancing rate, price to which commercial banks buy liquidities in order to give households and companies a loan, has gone down to the current amount of 0.05. It is not possible to decline further.

Consequently banks can lend more easily to companies and households. The objective is the reflation of the economy. Other ‘quantitative easing’ instruments exist and consist in creating money to then invest it in the economy. Their aim is to flood the economy with cash by injecting €1000 billion, which will be lent by the ECB to banks as long-term loans, on the condition they help companies with their investment projects. Even if the repurchase of government bonds is common practice in the United States and the United Kingdom, this last lever is not used by the ECB. When applying for a loan at the ECB without interest, the media talks about issuing money. 

However, the 1973 act forces the French state to borrow on financial markets to more or less high interest rates in order to limit inflation. That was the big fear of politicians at the time. This objective was already very debatable. While today France has paid €1700 billion interest rates and has €2000 billion government debts, should it not go back? Indeed, depending on the years the repayment of interests is the 1st or 2nd budget item for France.

To go further other solutions can be considered. The fall in the euro’s value could for example allow southern countries to improve their competitiveness and thus to realize commercial surpluses. The strong euro is the major cause of deflation, when one looks at the euro area as a whole, it produces €200 billion external surpluses per year, that is to say 2% of the entire GDP. It also contributes to most surpluses of Germany. Let’s take the automotive sector’s example with a Mercedes at €100,000, a Renault at €18,000, and a Hyundai at €20,000. If €1 is equal to $1, the wealthy population will buy the German car and the middle class the French car, because the latter are interested in the price. On the contrary, with the classic situation where €1 is equal to $1.4, the Mercedes would be worth $140,000, the Renault $25,200 and the Hyundai still $20,000.

Consequently the wealthy population will always buy the Mercedes as they want to acquire a social status, which means 40% income surpluses for Germany, and when it comes to the couple with financial difficulties, they will buy a Hyundai, thus Renault will lose market shares. According to politicians, one should follow the German model by producing premium products. Nevertheless, quality range differences come from structural problems that will necessitate years to be resolved. While Germany is leading Europe, so it seems rather unlikely to experience a fall in the euro especially as the country evokes the risk of a trade war, where all countries would try to decrease their currency’s value to become more competitive. 

Currently the obvious measures taken are not sufficient. Even in Germany, the slowdown impacts the growth with 1.3% in 2014, instead of the 1.9% expected at the beginning of the year. It seems the euro area’s homogeneity is blocking the situation as countries have completely diverging economic interests. Nevertheless, everybody agree on the numerous problems caused by deflation: an economic activity’s reduction, a fall in households’ consumption and in companies’ production, because of a reduction in staff or salaries due to the decreasing consumption. This way households’ revenue will go down and the vicious circle will constantly carry on.