Tag Archive for inflation

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.

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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:

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Inflationary pressures to stimulate efficiency?

Under a fiat currency regime, the purchasing power of currency will continuously be devalued over time as new currency is printed to settle previous debts. In an ideal world, productivity and growth will increase proportionally with the nation’s money supply. Thus the value of money remains stable and static.

Unfortunately, since the dawn of mankind, this theory has never been realized as debt has always superseded productivity under this monetary policy. This is often counter balanced by increasing the money supply in the hopes that new businesses and thus productivity will grow.

What about efficiency of production? Towards the middle of a crisis, innovation is spurred as the cost of living increases and businesses are encouraged to cut costs while maintaining quality. Assets that are were once used by larger companies, now bankrupt, are bought by new smaller companies and they usually utilize these resources with great efficiency to survive the current economic crisis.

This can be seen today as automobiles move into smaller, technologically advanced engines. Outsourcing is booming to reduce costs from all areas of a business. One internet marketing company did a study where they found a trend in advertising towards increased R.O.I. Many companies have shifted their marketing budgets away from traditional marketing mediums like T.V, print, radio and moving towards online media such as search engine optimization, media buying and social media. This paradigm shift is simple to explain; the cost of customer acquisition is significantly cheaper through online methods where R.O.I’s can be as high as three times more than traditional media.

Clearly the future looks bright even though the current economic climate does not seem so. Like the years before us, the free market will eventually balance itself and this moment of hardship is simply that: a moment.