Deflation nations

The Price Is Right?

5806762920_2cca7cd572_z Michael king
No shop zone: a quiet day in Europe's oldest shopping mall.
  • Why it matters

    Why it matters

    The wrangling over the importance of deflation goes to the heart of how to tackle the euro zone’s ongoing economic crisis.

  • Facts

    Facts

    • The European Central Bank has vowed to bring inflation back to its target of close to but below 2 percent
    • A new study suggests falling prices do not cause consumers to put off purchases.
    • Other theories still suggest deflation has a major effect on companies that are in debt.
  • Audio

    Audio

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Mario Draghi was sure back in August 2013: “We see no deflation in the euro zone,” said the president of the European Central Bank (ECB).

The main reason for his certainty wasn’t necessarily the numbers, which already then showed prices falling in some euro zone countries, even if prices were positive on average. The reason was Mr. Draghi’s definition of deflation, as a sustainable, self-reinforcing decline in prices that causes consumers and investors to put off their purchases in the expectation of even lower prices in future.

Nevertheless, over the following 13 months, Mr. Draghi and the ECB’s Governing Council, its key decision-making board, shifted their stance and agreed to a series of comprehensive measures to guard against the risk of deflation. In doing so the ECB, largely unnoticed, has changed its theory and pivoted to becoming a deflation-fighting protagonist.

This shift over how to tackle deflation goes to the heart of the debate over how to deal with the euro zone’s ongoing economic crisis. Some economists have argued that a bout of deflation is not such a bad thing – many southern European countries in particular saw prices rise too sharply in the decade before the 2008 financial crisis. The ECB, however, is arguing that deflation is something that must be prevented at all costs.

Back in August 2013, the ECB’s task was simply a matter of keeping the inflation expectations “firmly anchored,” because this would preclude the deflationary spiral feared by Mr. Draghi. But in the following months, Mr. Draghi came to realize that the dangers of a sustained fall in prices go beyond merely causing a wait-and-see attitude among consumers. That is because there are many other more important hidden aspects, such as the effect on those in debt – whether the public or governments – who will suddenly face a higher bill to pay back.

In addition, the theory behind the presumed effect of deflation on the consumer is not especially sound. “Our results show that the widely-held fears of negative effects of deflation on consumption have a weak basis,” according to a study released in July by the Kiel Institute for the World Economy (IfW).

The deflation theory originally came from James Tobin, a Nobel Prize winner in economics. “If you expect falling prices, you will postpone purchases, preferring to hold money rather than buy goods,” Tobin wrote.

That’s because putting money under a mattress, or leaving it languishing in a checking account, still brings you a nominal interest rate of zero. If prices fall by 2 percent per year, that corresponds to a real interest rate of 2 percent. That is as the same as the bank giving you 2 percent interest on your money when prices are stable.

IfW economists think they have disproved Tobin’s theory. They looked at goods where prices are expected to fall over the long term, such as digital cameras, and reported no consumer caution in their buying habits.

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