Why we fear deflation

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13 October 2014 Est. reading: 5 min read

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.

Tracking the Eurozone's deflationary descent

What happens to debt burdens and balance sheets when prices fall?

When prices are falling and companies and workers can’t pass their costs on via higher prices or wages, their debts get worse, not better. If you have debts, the burden of paying them expressed in terms of your wages or price becomes more onerous. Therefore, good debt goes bad, performing loans become delinquent.

The central bank cuts rates to stimulate the economy. Rates move towards zero, but credit growth continues to head south. Why is this? It is because debt/deflation is taking hold. Interest rates don’t work. Because the private sector and/or the public sector has too much outstanding debt, it doesn’t want to borrow new credit and because the banks have too much bad debt, they don’t want to lend, irrespective of how low the interest rates go.

This is a liquidity trap and the economy is stuck.

As bad debts mount on both the balance sheets of the private sector and the banks, demand and income contracts further. This means that debt ratios actually rise because income is falling faster than debt is being paid off. In turn, debt to income ratio rise not despite but because of efforts to pay off debt. To introduce aggressive debt repayment schedules while in a liquidity trap is like putting an anorexic on a diet!

David McWilliams with Neil Woodford

When the economy is caught in the twin embrace of falling prices and too much debt, the paradox of aggregation comes into play, whereby what is good for the individual may not always be good for the collective.

The banks, now worried about their own balance sheets, urge the debtors to sell their assets to repay outstanding loans. For the individual debtor this sounds good. They will sell the asset, get some cash, pay off what they can and clean up their balance sheet. They will de-lever and become solvent.

But what happens if everyone tries to de-lever and sell at the same time?

The paradox of de-leveraging tells us that the price of assets will collapse because the markets will be flooded by distressed sellers, who de-lever their way to bankruptcy by crystalising losses, leaving the economy with asset price deflation. The debtor risks the paradoxical conclusion where the more he repays, the more he owes.

We are seeing this development in both the public and private sectors in Europe. Some people may acknowledge that markets can behave perplexingly and irrationally at times if in great stress, but they still hold to the notion that eventually wages adjust downwards and in time, the economy will clear at lower prices.

This textbook economics doesn’t work in practice.

In reality wages don’t fall, particularly in the Eurozone. Trade unions and public sector interests – the Insiders – move to protect their own workers. Wages in the protected sector change little. The adjustment doesn’t come through lower wages; it comes through higher unemployment for those on the outside – the Outsiders.

Lastly, with deflation, falls in income and rising debts cause the velocity of money – the amount of times money changes hands – to fall. This puts further onus on monetary expansions and further limits the effectiveness of central bank policy.

Taken together, you can see why the ECB wants to avoid debt deflation. Fighting deflation makes fighting inflation seem like a doddle. Just ask the Japanese, where the public debt to GDP ratio is now above 200%.

This explains Draghi’s urgency to halt stalling prices now because he knows if inflation falls below zero, Europe is in big trouble. The solution to deflation is inflation and Draghi knows this. That is why he will do “whatever it takes” to convince a sceptical Germany, still traumatised by a hyperinflationary past, to join him on an extraordinary monetary policy crusade.

David McWilliams (Twitter: @davidmcw) is one of Ireland’s leading economic commentators and was the first economist to identify the Irish boom as nothing more than a credit bubble, warning of its collapse and the consequences for the country. His objective is to make economics as widely available and easily understandable on as many platforms as possible. His daily market commentary www.globalmacro360.com is read by tens of thousands of his over 230,000 Twitter followers.

Woodford Investment Management Ltd is authorised and regulated by the Financial Conduct Authority (firm reference number 745433). Incorporated in England and Wales, company number 10118169. Registered address: 27 Old Gloucester Street, London, WC1N 3AX.

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