Europe Is Flirting With A Bizarre New Kind Of Economic Meltdown That Hasn’t Been Seen Since The 1930s

MIKE BIRD

OCT. 15, 2014

REUTERS/Tyrone Siu

Inflation is crumbling across Europe. In fact, in several countries, it’s already negative. Economists are increasingly worried that the whole continent is going to drop into deflation.

Most people don’t know what deflation means. We’re familiar with its opposite, inflation. That’s the condition in which prices keep rising, the value of money keeps falling, and people end up having to pay huge sums for small amounts of goods — like they are in Venezuela right now.

For most people, deflation will be a scary, new, rare kind of economic meltdown. And it can be far more difficult to fix than inflation. It involves uncontrollable falling prices. While that sounds great — everything is getting cheaper! — it’s actually a disaster because in deflation no one wants to buy anything, there is no demand, and economic growth grinds to a halt, bringing employment and productivity with it.

Here is how we got into this mess.

The European Central Bank and the Bank of England both target 2% inflation, like the US Fed. That rate keeps prices basically stable, and people are incentivized to be productive because they know in future their money will be worth a little bit less. But that “less” isn’t too catastrophic in the short-term — it allows people to plan ahead, in other words, and plan for growth.

But they’re nowhere near that level of healthy-but-minimal inflation. They’re way below it, flirting with deflation.

Here are the latest deflation figures from Europe, for September. 

• Italy: -0.1%. Italy is in its second month of deflation
  
• Spain: -0.3%. Spain has the most serious deflation of any large eurozone economy, it’s in its third consecutive month
• Germany: 0.8%. The fact that Germany has some of the highest inflation in the eurozone tells you a lot.
• France: 0.4%. A five year low. Core inflation is actually now at zero, the lowest in modern history. 
• The UK: 1.2%. The UK isn’t in the eurozone, but inflation is also at a five year low.

That’s making economists extremely worried about deflation, when prices go completely into reverse. The International Monetary Fund’s latest world economic outlook (WEO) has put the probability of deflation in the eurozone at 30%, up from 20% earlier this year.

IMF

So prices are falling. Who cares? When the price of goods falls, isn’t that a good thing?

There’s a good kind of deflation

It seems completely counter-intuitive to be annoyed about deflation. Economists seem to get wound up, but when was the last time you heard a normal person complain about spending less on their shopping?

Of course, that’s true. There’s such a thing as benign deflation. Take, for example, smartphones. The phone in my pocket has more computing power than several slightly older devices put together, so the price of that computing power has clearly dropped.

That’s good, supply-driven deflation. Productivity and technological development mean with that the same amount of money, I can now afford a far superior product. 

But there’s a pretty awful kind too

This sort of deflation isn’t the kind that economists are getting wound up about. Prices aren’t grinding lower in Spain because workers there are suddenly massively more productive.

In fact, falling prices are a symbol of a lack of demand. In a recession, demand drops significantly, and so companies cut prices to offload what they’re making. That’s the negative type of deflation, and if it sets in, it can be pretty harmful. Economist David Beckworth wrote a great, longer explanation about the difference between benign and malign inflation.

Here’s why it’s so dangerous

Let’s take Italy as an example. Italy is still running a deficit, and accumulating a national debt. When deflation sets in, tax revenues from sales decline, because prices fall. If property prices decline, income from property taxes decline, and so on. When your public debt looks like this, that’s a concern:

Capital Economics

They could cut government spending, but if deflation continues, they’ll have to keep cutting forever, going into a sort of permanent austerity. 

Falling prices also discourage business investment. Why spend money on machinery today, when you could buy it in two years for a lower price? For normal consumers, why spend today when I could just hang onto my cash? It’ll be worth more in a year’s time.

Over the long term, wages also have to fall or unemployment will rise. Companies taking a decreasing amount of income from what they make and sell will eventually have to cut their wages or lay people off. Nobody likes taking a pay cut, so this usually means a lot of people being laid off. Feel-good effects from lower prices aren’t likely to last very long if you lose your job. 

And that’s the nightmare scenario that Europe is gazing at right now: Long-term deflationary unemployment, in which no one works because no one is buying anything.