Of all the financial pathologies to afflict an economy, too much debt combined with simultaneously falling prices, can tip an economy from recession into depression, from which it is extremely difficult to escape.
This is what the Eurozone is facing now and it is why the ECB is tearing up the old Bundesbank rulebook and, in the process, driving a political wedge between the German monetary traditionalists and financial pragmatists in the rest of the Eurozone. This struggle will be one of the dominant political battlefronts of next year. The stakes couldn’t be higher. The ECB is just now beginning to realise that the gravitational pull of falling prices is so strong that it cannot be counteracted using monetary policy alone. There is a real danger that the debt deflation dynamics outlined classically by Irving Fisher in the Great Depression become embedded with catastrophic consequences.
Why does deflation become so engrained?
In a normal economy, people and companies buy and sell stuff to each other. In the Eurozone, we all buy and sell to each other. As the Eurozone is a pretty closed economy, each country’s spending is another country’s income. France buys from Italy and vice versa. France’s spending is Italy’s income. The same equation holds at a personal level: your spending is also my income and vice versa.
If there is a shock to demand, such as a massive Eurozone financial crisis, people and companies get worried about the future and they start saving for the rainy day. But if everyone is saving, who is spending? And if no one is spending what happens to income?
Typically, if the private sector is saving, governments will take up the slack, but if they don’t, overall spending falls and so too does, by definition, income. As debts are expressed in terms of income, if income is falling, debt ratios are rising without any new debt being incurred. Out on the street, retailers experience a sharp fall in demand for their products. So what do they do? They cut prices to coax people into the shops. But because our incomes are falling, something strange happens deep inside our heads. We don’t see the new lower price as a bargain, but as a harbinger for further price falls. So rather than encouraging people to come out and spend, the very fall in prices repels demand. Soon, people expect prices to keep falling.
In the same way as expectations of rising prices can become embedded, so too can expectations of falling prices.