The European Central Bank seems focussed on showering commercial banks with new money. But Quantitative Easing will not fix all the problems over the next 18 months. These are rooted in a lack of structural reform and growth. Eurozone prices have dropped 0.6 per cent in the last 12 months and signs are that prices will remain stable.
Most commentators have been following two major events over the last few weeks – the European Central Bank’s presentation of the Quantitative Easing programme and the Greek elections. Deflation is drawing less attention.
Few have concentrated on the 0.6 per cent drop in consumer prices between January 2014 and January 2015.
Does this reveal that a new scenario is about to open up or that deflation is here to stay, and is no longer a problem? Or are most economic commentators underestimating a threat which could cause serious problems in the not too distant future? And what is the impact for households and companies?
There are a few self-evident facts.
First, when prices change and agents have not taken action to insure against this possibility, people’s purchasing power adjusts. For example, when the price of oil drops by half, as it has over the past six months, purchasing power is transferred from oil producers to oil consumers. Likewise, when the price of coffee rises – up 20 per cent in the last year – coffee producers are happy, while coffee consumers face higher bills.
A generalised rise or fall in the price level – inflation and deflation respectively – can also involve a redistribution of wealth. Inflation favours debtors particularly as it reduces the real value of their debts. By contrast, creditors are happy when prices fall, as this ensures that the purchasing power of what creditors get back from their debtors increases.
Fear of future
Second, there is nothing particularly evil or weird with price changes.
Historically, people used to fear inflation as it signalled the presence of artificial bottlenecks or natural disasters, such as a new tariff or a bad harvest. By contrast, deflation was welcome as this often signalled fast technological progress, healthy competition, and increases in productivity.
But, third, the presence of inflation or deflation may also signal a change of expectations. For example, inflation could result from an optimistic view of the future. If so, companies and individuals tend to consume and invest more than they produce. This leads to excess demand and, therefore, inflationary pressures.
However conversely, when individuals fear for their future, they tend to reduce consumption and companies hesitate to invest. Aggregate demand then drops, and prices tend to fall – deflation – during the time it takes for supply to adjust.
Lack of growth
There are reasons to be happy about deflation, but two reasons to worry about it.
The first source of concern relates to situations where deflation causes an undesirable redistribution of income and /or wealth. The second is when deflation heralds pessimism about the future.
These are the reasons the authorities and public opinion have had front of mind over the last few years. However, although they were right to worry about deflation, policymakers were wrong to fight it.
Trying to tamper with your thermometer is not the best way of getting rid of flu. The flu in this case corresponds to the presence of many bad debtors – including governments – and to the lack of significant growth in several European Union economies.
The fact that deflation no longer takes centre stage is good news, as long as it means that the European Commission in Brussels and the ECB in Frankfurt have realised that the real problems are public debt and widespread inefficiency and that growth is the best way of curing pessimism and deflation.
The bad news is that the lack of emphasis on deflation could merely witness a sense of relief following the approval of Quantitative Easing – a programme which will probably freeze the public-debt problem until mid-2016 or longer, but is hardly likely to create the conditions for future healthy growth.
Growth will depend heavily on oil at knock-down prices and a weak euro unless some key member countries engage in substantial reforms.
Cheap oil and a weak euro could promote growth. But it cannot be certain that these elements will last long enough to change people’s mood and end stagnation.
Oil price benefits
Overall, we believe prudence will prevail, that the rise in consumption and investments in the eurozone will be positive but limited, and prices will stagnate or rise very slowly.
This is not a very encouraging scenario, but there are no alternatives. Companies and households should be grateful for the drop in oil prices and the exchange rate adjustment. But they should also be braced for ongoing quiet, the slow growth in the eurozone, regardless of the ECB’s aggressive monetary policy.
Inflation is not a realistic scenario for the immediate future.
Households can rejoice. A considerable share of their financial wealth consists of fixed-income bonds issued by governments and private companies. Inflation would quickly erode the value of those bonds, and households would suffer.
To make matters worse, the rise in prices might not be the result of real economic improvements, but the consequence of the significant amounts of money created by the European Central Bank over the last few years. If so, production would be likely to stay put, and so would salaries. This would mean that real incomes would fall.
Put differently, a bout of inflation could hit households twice – their financial wealth would shrink and their real revenues – salaries – would find it hard to keep in step.
Price stability is a better regime for those who enjoy limited bargaining power on the jobs market, and/or are unable to reshape their portfolios and move quickly, and in the right direction, on the stock markets.
Large companies would see things differently. They have issued large amounts of bonds over the last few years, and inflation would be an easy way of reducing the real value of their debts. The same applies to governments but on a larger scale.
Nonetheless, we believe that despite the ECB’s generous monetary policy, the new money is likely to be hoarded, rather than spent.
Prudence will prevail and spending is going to remain subdued as long as some key countries such as France and Italy fail to engage in serious reforms and show convincing results.
However, price stability could turn out to be problematic for those producers who went into heavy debt hoping inflation would bail them out.
We fear that a significant number of eurozone companies actually have followed this path during the recent past, and this could explain why the ECB is eager to let banks have so much liquidity.
If we are correct, that new liquidity will not finance new entrepreneurial activities over the next few months, but will bail out troubled companies which believed that indebtedness would allow them to resist competitive pressure, and inflation would help them settle the accounts with their creditors.
We think the prevailing short-run scenario will feature price stability as in the past four years when serious deflation has never been a real issue.
This is good news for creditors such as households and for all those who find it difficult to adjust. And it should be good news also for the ECB. Its mission is ‘price stability’, not ‘moderate inflation’.
Companies which have failed to improve their performance during the last few years and hoped to make money thanks to monetary tricks will be bruised.
In this light, arguing in favour of inflation is a dangerous illusion.
Structural reforms and new healthy business remain the key to recovery. If these materialise, we shall have grounds for optimism and the debate on deflation will be filed away.
If we do not see positive reforms, we are going to live with large numbers of ailing companies.
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