The Possibility of European Deflation

Euro zone inflation rate

The euro zone has struggled mightily in recent years, with its economy shrinking in both 2012 and 2013. Now it faces a new worry. Inflation in the euro zone has fallen to a 0.4% annualized rate, well below the target of close to 2% set by the European Central Bank (ECB) and close to outright deflation. The dangers of high inflation (a sustained rise in the prices of goods and services throughout the economy) are well known: it reduces the value of people’s savings and can make individuals and businesses reluctant to invest. So shouldn’t deflation (a decline in prices) be beneficial? Not exactly.

There are a number of ways that deflation harms an economy. First, since the amount owed on loans and bonds stays the same even if the price of goods and services decline, deflation can make it more difficult for individuals, businesses, and governments that have borrowed money to get out of debt. Just as inflation hurts bondholders, deflation hurts debtors.

Second, it tends to be easier for companies to raise wages than to make their employees take pay cuts. Therefore if prices are declining so companies can’t pay their workers as much, they are likely to lay off more employees, leading to higher unemployment.

Third, when people see prices falling they may respond by postponing their purchases until prices go down even further. A decline in prices can therefore lead to reduced demand, causing further price declines (a “deflationary spiral”).

The euro zone may already been feeling some of these effects, since they can start to kick in when the inflation rate is persistently low, even if it’s still above zero.

Unlike the central banks of other developed countries such as the US, UK, and Japan, the ECB hasn’t engaged in “quantitative easing” (essentially creating new money and using it to buy bonds). This difference is one reason why expected future inflation is now substantially lower in the euro zone than in the US or UK. To avoid the perils of deflation, the ECB may need to take more aggressive action to prop up the continent’s economy.

Checking in on Abenomics

Shinzo Abe

When Shinzo Abe was elected as Japan’s Prime Minister in December 2012, he launched a bold plan of economic reforms that became known as “Abenomics”. These reforms included increased government spending, more purchases of government bonds by the country’s central bank, deregulation, and new international trade agreements. The aim was to jolt the country out of two decades of stagnation that had been characterized by deflation and mediocre economic growth.

Almost a year and a half into the implementation of this reform agenda, Abenomics appears to have made some progress. The value of the Yen, the country’s currency, has fallen by more than 20% since November 2012, helping Japanese exporters become more internationally competitive. The stock market has soared by 60% against the US dollar over the same time period (although for US investors some of that gain has been offset by the decline in the value of the Yen). Japanese wages rose in February for the first time in almost 2 years, suggesting that the quest to end deflation may finally be bearing fruit.

That doesn’t mean that Abenomics has been unequivocally successful. Many of Abe’s proposed regulatory reforms, such as breaking up the country’s electricity monopolies and loosening rules about how companies hire and fire workers, have struggled to gain support.  Some critics, such as economist Edward Hugh, argue that Abe’s attempts to stimulate the economy will ultimately fail.

The mixed outlook is reflected in the gyrations of Japan’s stock market: the overall rise since Abe’s election masks a few large drops, including a decline of more than 10% so far this year. Despite some early signs of success, the jury is still out on whether Abenomics will resuscitate Japan’s economy.