Archive for August 21, 2014

The European Deflation Trap

At first glance, deflation doesn’t sound that bad at least not compared with lots of other economic woes that have recently beset the various economies of Europe.  It’s a situation that Portugal, Spain and Greece now find themselves with a very real possibility of being joined by the Italians.

One of the main reasons it sounds good is that of course, deflation means falling prices and in Greece they fell by just over 0.8% in one month.  In Portugal that figure was 0.7% and 0.4% in Spain, the Italians have at the moment a 0% inflation rate.

bbc news

So why is deflation bad? Well there are two main reasons and they are both centered around economic growth.   The first one is fairly obvious, for an economy to grow it needs people to spend and buy products and services.   Ask yourself the question – if prices are falling every month – will you make that big purchase or wait until it becomes even cheaper.  That’s a big reality of deflation – it acts as a disincentive to buy.  For the consumer it’s good but for the economy in general it leads to falls in profit and revenue, lower wages and a rise in unemployment.  All factors feeding in to reduce the growth of an economy.

The other significant issue is that deflation actually makes debt payments more difficult to afford.  Lower revenues, falling sales and profits mean companies and countries are unable to services their debts which can cause significant issues especially in the debt ridden economies of Europe.

The danger leads to a spiral of deflationary pressure, falling levels of consumption in turn lead to falling investment.  Both of these will lead to further falls in prices, this isn’t just economic theory either – Japan fell into this trap and took decades or more to recover, in some senses it still hasn’t. When the costs of goods starts to fall, then the revenue and profits fall too – it sounds good for a consumer but ultimately it isn’t.  Stable economies which slowly grow are best and for this to happen you need companies to expand and their profits to grow.  People don’t tend to buy luxuries buy proxy servers and expensive cars when their livelihoods look under threat.

Joseph Clarke: