It is presumed to be the equivalent of a flood, earthquake, severe storm and an epidemic to the Western economies based on various, neo-Keynesian, economic models and theory. The answer, based on real life but also historical evidence , is however that it is not. One could even say that a shot of deflation is what those economies need. Let us take a look at the recent real life examples.
Japan is the only Western country that has experienced protracted deflation in recent decades. As according to almost all economists, policy makers, central bankers and the media, deflation is a disaster as it causes households to postpone their spending, leading to falling consumption and high unemployment, Japan should be a country characterized by high unemployment, everything but bustling shopping scene, much lower standard of living than say 20 years ago and absent from every international comparison of economies in terms of innovation for example. Instead, Japan features at least in the top 5 of every ranking of the most innovative countries in the world, the consumption has increased despite years of falling prices, the unemployment rate is lower than 4 percent, Japanese streets are filled with shops selling everything known to man ánd people spending their money and the standard of living is second to none in the world. These are the facts. Of course, the Japanese experience with deflation might be the exception to the rule. Luckily, we have comparison material.
In the euro area, there are two countries that recently have fallen into deflation. In Greece prices have been falling since the begin of 2013. In Spain, the annual inflation rate started to nosedive at the end of the spring 2013 and it fell sharply, to 0 percent, in the autumn of the same year and has stayed there ever since, dipping below zero in the summer of 2014 and staying there since then.
If we take a look at the gdp growth in Greece, we find out that in the first quarter of 2013 it shrunk by a staggering 5,8 percent. In all subsequent quarters of that year, the Greek gdp continued to shrink, but the rate at which it did so decreased. In the first quarter of 2014 the economy lost just 0,4 percent of its size. That was the last quarter the Greek gdp shrank. Since then economic growth was back, first 0,4 percent but soon the growth rate rose to almost 2 percent. So the economy started to recover at the same time the prices started to fall. And the recovery is not artificial as at the same time the turnover at the Greek shops started to recover as well. Not exactly one would expect if one were to ignore the facts and fly by on economic models.
In Spain we see the same scenario unfolding. At the end of January if 2015, Spain reported 0,7 percent economic growth in the final quarter of 2014, the highest growth percentage in seven years. When we plot the growth of the Spanish gross domestic product (gdp) in recent years, we see that the rate of decline started to slow in the first quarter of 2013 and the economy actually started to grow in the third quarter of that year. The Spanish gdp has been growing ever since and the growth rate has been picking up: from 0,2 percent in the third quarter of 2013 to 0,7 percent in the last three months of 2014. As in the case of Greece, it is striking to see that the economic recovery coincides with the moment the prices started to fall sharply and the recovery took off when inflation rate turned negative.
Spanish gdp growth starts to recover at the same time inflation falls and prices start to decline
Further up in the north of the euro area, in the Netherlands, the inflation rate started its rapid decent in the summer of 2013. The annual rate of inflation fell from more than 3 percent to 1,5 percent in just couple of months and then some more. In less than a year, the inflation rate dropped from more than 3 percent to almost 0 percent and has been hovering just above that level until recently, when the prices fell even below 0 percent.
When we plot the unemployment rate, consumer confidence and consumer spending in the Netherlands in the same graph as the annual inflation rate, we see the same pattern we have seen in Greece and Spain: almost at the same time inflation rate tanked, consumer spending started to increase faster (it even increased at the fastest rate in years at one point), the unemployment rate started to fall and the consumer confidence staged a strong recovery. The gdp, which was contracting in every quarter starting with the beginning of 2012, started its ascent in the third quarter of 2013 and has returned to positive territory in the final months of 2013 where it has been ever since.
Why do these developments defy everything we have been hearing from central bankers and economists? In the first place because the general inflation rate started to decline mainly due to a fall or a relatively modest increase of food prices for example. In the last couple of months the sharp fall of the oil price pushed the energy-category of the inflation basket sharply lower. Food and energy are the two categories people spend a large part of their money on. If they need less money for those things, they can spend more on other goods and services. After years of tax hikes and other assaults on their income, people in various euro area countries actually started to have more money to spend. In the Netherlands for example, the fall of inflation had led to something the Dutch had not experienced in years: their wages rose faster than prices.
Still, central bankers refuse to acknowledge these facts and keep going on about the danger of deflation, often referring to the Great Depression. One thing we know for sure about deflation is that it increases the debt burden in real terms. One cannot help but to wonder whether this refusal to acknowledge the facts and vehement demonization of deflation to the point that it is used as the reason for quantitative easing in the euro area, has anything to do with the fact that many euro area governments carry a large debt which would become even larger with protracted deflation. Central banks are throwing everything at falling prices, something Joe Average actually needs badly.
Recently I spoke to the eminence grise of central banking, the legendary former chairman of the Fed, Paul Volcker. According to Volcker “the idea that when people see prices falling they will stop buying those cheaper goods of cheaper food does not make much sense. And aiming for 2 percent inflation every year means that after a decade prices are more than 25 percent higher and the price level doubles every generation. That is not price stability, yet they call it price stability. I just do not understand central banks wanting a little inflation.” Perhaps the central bankers and economists from all over the world should take a break from the theory and their focus on economic models and instead have a look at the real world and spend some time talking to Volcker in order to remember that inflation is everything but a good thing.
Wed, 25 February