The risks that deflation engenders are well known. First, by creating expectations that prices will be lower next year it gives consumers incentives to postpone purchases. As a result, aggregate demand declines putting further downward pressure on prices. Second, since private and public debts are fixed nominally, declining prices increase the real burden of the debt. Put differently, as prices decline government and private revenues decline while the service of the debt remains unchanged. This forces the private and public sectors to spend an increasing proportion of revenues to service the debt, forcing them to cut back their spending on goods and services. This in turn increases the intensity of the deflationary process. This is probably the most important negative effect of deflation.
Are these risks today close to becoming a reality in the euro zone? I would think that the first one, the consumption-postponement effect is not yet operative. Prices are still increasing in the euro zone. Only if consumers actually expect prices to decline will it start operating. We are not yet there.
The second effect, the debt-deflation dynamics, however, is already working. It is important to stress that this effect does not crucially depend on inflation being negative. It starts operating when inflation is lower than the rate of inflation that was expected when debt contracts were made. Thus, during the last ten years inflation expectations in the euro zone have been very close to 2%, which was also the average rate of inflation during that period. Current nominal interest rates on long-term bonds reflect the expectation that inflation will be 2% for the next five to ten years.
However, inflation in the euro zone has been declining since early last year and now stands at 0.8%. This disinflation exerts debt-deflation dynamics, which are of the same nature as those analysed by Irving Fisher. The nominal debt increases with the nominal rate of interest (which includes a 2% inflation expectation), but the nominal income in the euro zone increases by only 0.8%. As a result, an increasing proportion of these revenues must be spent on the service of the debt. Less is left over to spend on goods and services.
Thus, the euro zone as a whole already suffers from debt-deflation dynamics. It is not yet catastrophically intense, but surely it should be stopped before it gets worse when inflation turns negative.
These debt-deflation dynamics are now even worse in the countries of the euro zone with the highest debt levels. In Spain, Ireland, Portugal and Greece the rates of inflation are below 0.8%, the euro-zone average. In Greece inflation is negative, creating fully-fledged debt-deflation dynamics.
It is sometimes said that the individual countries’ inflation is of no relevance and that only the average inflation in the euro zone as a whole matters. In this view, the fact that inflation in the highly-indebted countries is below the euro-zone average is a good thing. It is part of a relative price adjustment. The troubled debtor countries’ prices decline relative to the northern euro-zone countries. This will boost their competitiveness and is part of a healthy rebalancing mechanism.
Although theoretically correct, the practical implication of this competitiveness effect is limited. There is today (with the exception of Greece) very little difference in national inflation rates in the euro zone. Germany’s inflation is 1.3% (the highest rate) while inflation in the highly-indebted countries, Ireland, Spain, and Portugal is 0.2 to 0.3% and in Italy 0.7%. Thus the competitiveness effect is extremely weak. What is left over is the debt-deflation dynamics that is doing its destructive work, more so in the indebted countries than elsewhere in the euro zone.
The only institution that can prevent disinflation from turning into deflation is the European Central Bank. But that institution is staying on the sidelines, observing and doing nothing. It is paralysed by internal dissension that prevents it from increasing liquidity in the system, the only sure way to prevent deflation
(Source: http://www.economist.com/blogs/freeexchange/2014/01/deflation-euro-zone-1)
I have always thought that deflation will be a positive phenomenon. However, after reading this article, I found that it is opposite from what I thought.
My question is: what is the balance between these? and how such balance can be achieved?
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