Thursday, 22 January 2015

Economics: Deflation 101

Europe is now talking about a possible deflation... Do people really know what a deflation is? And why the drop of prices is normally perceived as a problem?

What is a deflation?
It is a continuous and persistent process of decline in prices of goods and services considered essential and more "important" for the economy (prices of food, energy, transport, housing ...): this is normally called the Consumer Price Index. When the annual variations are continually going down, we enter a process of deflation, even if the values have not yet reached negative levels.

Why do prices go down?

The most common explanation is due to the effects of austerity policies that forced families to save more - postponing consumption - face the uncertainties of the future (more austerity measures, unemployment, etc.). Also the weak economic growth can also be a reason for low prices. Since mid-2014 the fall of the oil barrel price has also played a big role in this.

Isn't a good thing to have lower prices?
It is. But when prices start to fall from month to month or quarter to quarter, consumers will delay purchases. It is a matter of family expectations: "I think that in a few months the price of a particular product will be lower, so I'll wait for the most opportune moment.

Is that bad for the economy?
It is. You can create an expectation so widespread in the population that everyone defers consumption. Normally this requires companies to produce less; to produce less, need less workers (rising unemployment); but also require less raw materials (suppliers of these companies can also close); stocks increase - is a snowball, the cycle continues and eventually affect the entire economy. However, there are people that argue that countries can live in deflationary periods without jeopardizing economic growth, especially when the fall in prices is due largely to the depreciation of oil.

And what that has to do with debt deflation?
This is a second problem. With the widespread and continuous fall in prices, the goods cease to be worth as much, while increasing the real value of debt (nominal value remains unchanged) and as a result, households and businesses will have to put more money aside to pay that debt. This reduces even further the capacity for consumption and investment so the economy can stagnate.

And wages? Do they descend?
In a many economies you can not cut nominal wages. In the case of an inflation scenario companies can freeze the real value of wages, however with deflation the problem is very difficult to solve. Deflation has a larger effect, as prices fall workers have the perception of increased purchasing power (at end of month it seems that the salary "stretching"). The truth is that, with a "lower" cost of living, employees will not negotiate salary increases and due to the associated unemployment rates, employees end up accepting lower pay when applying for new jobs.

What can be done?
The central bank can push for the decline in the benchmark interest rate. In the case of the eurozone, this alternative is no longer viable: the rate is at historically low levels (0.05%) and download more would have no effect on the economy.
Central banks have other solutions - less orthodox - passing by flooding the market with money. This has been the policy of the Federal Reserve US, the Bank of England and Bank of Japan.

What measures are the ones that the ECB may take?
The European Central Bank has a clear mandate to keep inflation below but close to 2%, a goal that has clearly failed. The Consumer Price Index in the Eurozone went into negative territory in December (-0.2%) and this is far from the goal set in the treaties. After several ECB interventions to try to liven up the economy and raise prices, there are many options left. The most likely candidate is the massive purchase of debt - the so-called "quantitative easing" (QE).

How does QE work?
In general, such programs require the purchase of public and private bonds from banks in order to free money for the economy. In the case of the European Central Bank is still not known how the intervention will be made.

How can countries benefit from QEs?
  1. buying debt from banks, releases credit to the economy (consumption and investment);
  2. decrease of the interest rates on public debt;
  3. confidence "injection" in the economic agents.

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Blog Editor and Owner: Luis Aparicio Fernandes (or Mikey) is a Business Expert and a Traveler based in London, UK. He is a member of The International Honor Society Beta Gamma Sigma due to his achievements in business. You can follow Luis on Google+, and LinkedIn.