Is deflation a major threat to the eurozone?

In its October 2012 World Economic Outlook report the International Monetary Fund (IMF) said that the European Central Bank (ECB) should keep interest rates low for the foreseeable future and may need to cut them further given the risk of deflation.

Now, even if the IMF is correct and prices in the Euro-zone will start falling, why this is so bad?

The conventional wisdom holds that price deflation causes people to postpone their buying of goods and services at present on the belief that the prices of these goods and services will be much lower in the future.

Hence why buy today if one can buy the same good at a bargain price in the future? As a result a fall in consumer outlays via the famous multiplier will lead to a large decline in the economy’s rate of growth.

In fact deflation could set in motion a vicious downward spiral, which could plunge the economy in a severe economic slump similar to the one that took place during the Great Depression of the 1930’s, or so it is held by most experts.

It is for this reason that the IMF is of the view that the ECB should push the policy interest rate further down.

Now, if deflation leads to an economic slump then policies that reverse deflation should be good for the economy.

Reversing deflation would imply introducing policies that support general increases in the prices of goods, i.e., inflation. This means that inflation could actually be an agent of economic growth.

According to most experts, a little bit of inflation can actually be a good thing. Mainstream thinkers believe that inflation of 2% is not harmful to economic growth, but that inflation of 10% could be bad news.

We suggest that at a rate of inflation of 10% it is likely that consumers are going to form rising inflation expectations.

In response to a high rate of inflation, consumers will speed up their expenditure on goods at present, which should boost economic growth. So why then is a rate of inflation of 10% or higher regarded by experts as a bad thing?

Monetary pumping will undermine economic fundamentals

Contrary to IMF thinking, a strengthening in the pace of money supply rate of growth and a further lowering of interest rates will not strengthen economic fundamentals but will further weaken the Euro-zone ability to generate real wealth.  Monetary pumping and a lowering of interest rates leads to misallocation of resources – it diverts real wealth from wealth-generating activities towards non-productive wealth-consuming activities thus putting pressure on the overall pool of real wealth.

As a result the sovereign debt crisis will only get much worse since the ability of various governments to honour their debt repayments will only weaken further. Remember a government is not a wealth generating entity; it can only pay its bills and repay its debt if the private sector generates enough real wealth for that.

Now, contrary to the popular way of thinking, inflation is not about a general rise in prices as such but about increases in the money supply. Likewise deflation is not about a general fall in prices as such but about a decline in the money supply.

As a rule, a general rise in prices occurs on account of previous increases in money supply. Likewise, a general fall in prices occurs on account of previous fall in the money supply.

Following the definition that deflation is about a fall in the money supply, which can manifest through a decline in the prices of goods and services, one could infer that deflation cannot emerge without previous inflation, i.e. previous monetary pumping.

The key factor behind a fall in money supply is the central bank’s policy, which inflates the money supply. Once the side effects of this inflation become unacceptable to central bank policymakers they reverse the loose stance.

Once banks’ lending out of “thin air” – which emerged on the back of the loose monetary stance of the central bank, starts to evaporate – the money supply follows suit.

Obviously, on account of deflation, i.e. a decline in the money supply, various bubble activities that emerged on the back of previous loose monetary policy of the central bank come under pressure – they cannot stand on their own feet without the support of loose monetary policy.

The demise of bubble activities is great news for wealth generators; they can now have more real wealth for themselves and employ it in the expansion of the overall pool of real wealth.

Fall in prices enables the spread of real wealth across the economy

We suggest that a fall in prices that follows the decline in money supply is the mechanism that enables wealth generators to spread the increase in real wealth across the economy. A given dollar can now secure more goods and services – the purchasing power of the dollar is now rising. Why then should this be regarded as bad news?

Contrary to the popular way of thinking, there is nothing wrong with declining prices.

According to Salerno,

In fact, historically, the natural tendency in the industrial market economy under a commodity money such as gold has been for general prices to persistently decline as ongoing capital accumulation and advances in industrial techniques led to a continual expansion in the supplies of goods. Thus throughout the nineteenth century and up until the First World War, a mild deflationary trend prevailed in the industrialised nations as rapid growth in the supplies of goods outpaced the gradual growth in the money supply that occurred under the classical gold standard. For example, in the US from 1880 to 1896, the wholesale price level fell by about 30 percent, or by 1.75% per year, while real income rose by about 85 percent, or around 5 percent per year.[1]

Moreover, to suggest that consumers postpone their buying of goods because prices are expected to fall would mean that people have abandoned any desire to live in the present.

However, without the maintenance of life in the present no future life is conceivable.

On this Menger wrote,

An imperfect satisfaction of needs leads to the stunting of our nature. Failure to satisfy them brings about our destruction. But to satisfy our needs is to live and prosper. Thus the attempt to provide for the satisfaction of our needs is synonymous with the attempt to provide for our lives and well-being. It is the most important of all human endeavours, since it is the prerequisite and foundation of all others.[2]

Now, from December 1997 to August 2012, the prices of personal computers in the US have fallen by 94%. Did this fall in prices cause people to postpone buying personal computers?

On the contrary, since December 1997 consumer outlays on personal computers have increased massively. These outlays stood at $123.050 billion in August 2012 as compared to $3.4 billion in December 1997 – an increase of 3,519%.

Summary and Conclusion

In countries such as Greece and Spain what is currently required is the establishment of the conditions for a quick build-up of real wealth. Printing more money and providing more loans to these countries governments is not going to be of much help. On the contrary it will deepen the economic impoverishment and will prolong the economic misery.

What is currently needed is to cut government outlays to the bone and the closure of all the loopholes for the creation of money out of ‘thin air”.

The government and the central bank should step aside and allow entrepreneurs to revive the process of wealth generation, i.e. allowing the private sector to build up the national pie.

The major threat to the Euro-zone comes not from a possible general fall in prices but from the IMF’s recommended policies that once implemented is going to weaken further the process of wealth generation.

[1] Joseph T. Salerno An Austrian Taxonomy of Deflation presented at “Boom, Bust, and the Future,” January 19,2002, The Mises Institute, Auburn, Alabama p 8.

[2] Carl Menger Principles of Economics New York University Press p 77.