The Risk Of Deflation In The Eurozone

In January, Lucas Papademos, Vice-President of the European Central Bank ECB), strongly suggested that inflation would not fall much below 2% in the eurozone (see the end of this post).  Translated from the language of central bankers, he implied that the risk of deflation in the eurozone was virtually nil.

Now Jean-Claude Trichet, head of the ECB, with reference to the latest eurozone (0%) inflation rate, says that we should disregard the data because a recovery is just around the corner.

Alternatively, we are close to the baseline eurozone view laid out in my January presentation (part of a panel discussion with Mr Papademos).  You can break this down into three specifics.

  1. Private sector demand is weak; it’s hard to see who will lead the recovery within the eurozone.  In addition, the demand for European exports has fallen much more than expected, as seen – for example – in the big decline in German Q1 output.
  2. The ability of the public sector to offset this decline with discretionary fiscal policy is quite limited, due to balance sheet constraints in some countries (look at the latest credit default swap data from weaker euro sovereigns; CDS primer) and clear policy preferences in others (i.e., how Germany worries about inflation, even when there is none).
  3. Banks look troubled across many eurozone countries, and as the real economy surprises on the downside these problems will increase – with presumed implications for government bailout programs and balance sheets (the IMF was quite negative, see Tables 1.3 and 1.4 on pp.28 and 34 respectively, on European banks before the latest round of bad news).  Remember that the European economy depends on banks much more than does the US.

If the world turns around and/or oil prices continue to rebound, the eurozone can presumably avoid deflation.  But it’s hard to see inflation rising any time soon due to the eurozone’s own dynamic.

And if deflation takes root, it is hard to see this proving more tractable or less damaging than deflation in Japan during the 1990s.  Which part of Japan’s lost decade now looks easy to avoid in Europe?

By Simon Johnson

12 thoughts on “The Risk Of Deflation In The Eurozone

  1. This morning, Krugman was talking about the inflation fear-mongering. I agree with him in that if there is going to be ANY inflation, it will only come about as a result of deficit spending at the federal level. But the banks are hoarding more than what Obama is doing in additional spending. So the hoarding negates any inflationary effect that the spending may have had. Where I disagree with Krugman is in his assertion that more government spending is going to “rescue” the American economy. The hoarding door can swing both ways and bank hoarding can also keep any positive effects from occurring. But eventually, unless we plan on making such expenditures a permanent feature of the economy, we simply MUST address the underlying issue…stagnant wages.

    Either wages must come up or prices must come down. Conservatives want to give us lending and credit to make up for the difference between wages and prices and “liberals,” or what I like to call neo-liberals, want to avoid the wage issue too and give us government spending. Where do they think the tax money comes from to pay for all of this spending? Doesn’t it come from…. wages?

    But I don’t see wages going up any time soon…except maybe for the rich. No, the only thing I see are falling prices. There’s no other way out but to deflate this overly-inflated economy. Home prices, car prices, college costs, luxury items at the mall…everything that was being purchased on time before this mess began must come down.

  2. My understanding of the grounding for most of the fears is that people see low interest rates (unprecedented near-zero ones) and QE and assume that these are inflationary. They are. The trouble is, they do very little to counteract the deleveraging of £bn, $bn and €bn from the banks, which is deflationary (as is the recession itself).

    This is why I’m looking forward to the day, perhaps in 2019, when the news announces: “inflation hits a 10 year high of 2.3% following a further rise in the oil price, to $180.” Because I can’t see inflation much above 2% happening without a recovery, nor a recovery without oil soaring once again.

  3. Inflation risin$g any time soon due to the eurozone’s own dynamic.

    As my fellow north European cash-saver with a deep trust and vested interest in their currency, I do not believe in anything like the Japanes scenario here, let alone the US 30s one to take hold here. No gold standard, no crushing down-pricing spiral.

    Bernanke and al certainly try to avoid “asset repricing” like plague. But the current price level for housing is the plague. It does not make economic sense to try to keep prices up in their current stratosphere. It just won’t happen anyway.

    This is no deflation. This is repricing as JC Trichet forewarned about in Davos, 2007 version, as far as I can remember.

    I understand that a lot of people have vested interests in cranking up the old stuff up at anyone else cost. Is is keynesian policy? Possibly if you believe there is any resemblance between US 1929 and US 2009. Is it a decent financial proposition ? No

    Crashing the dollar is certainly a distinct possibility ? An achievement you can de proud of, I’m afraid not.

  4. We are experiencing the drawn out results of an economic system that has been corrupted to favor the corporate elite and the oligarchs. Until these people are knocked off of there lofty perches, the nation will founder. Not by inflation or deflation, but by extreme volatility as the vampire capitalism sucks the world dry.

    There is currently a vast plug of overpriced products in the pipeline and nobody wants to mark it down. They are hoping that the suckers will have to buy this over-priced stuff because there is such a thing as pent-up demand. Eventually you really do need to buy a car or fix your roof or get a new lawnmower. You can only put it off for so long. But guess what, folks? Now that manufacturers are cutting back inventory at the most rapid pace ever, all of a sudden there are going to be shortages. Then the over-priced stuff will suddenly disappear and you won’t be able to find what you need. This is the dead cat bounce. Just because the cat bounces does not mean it is still alive.

    Wake up world! We have to take back some of the ill-gotten gains made possible by Bush and his henchmen. We have to redress what is considered allowable in corruption and avarice. A free market economy cannot long survive an obviously corrupted legal framework. So far, it does not appear as if any public officials are ready to take on the corporatists. But they may need to reconsider. Otherwise the tax base may evaporate.

  5. As the largest economy in the Euro Zone, Germany has yet to address fundamental weaknesses in its own financial services sector – see:
    This gives a clear overview of the financial crisis facing the FDR.
    I note Austrian banks have huge exposure to the former Eastern Bloc nations that have joined the EU, as has Greece and Italy in the Balkans. Both Ireland and Spain have suffered huge property price falls and the regions population growth is set actually to decline in the years ahead.
    Given the number of huge economic problems and the Bundesbank’s great fear of inflation, I fail to see where exactly these inflationary concerns are going to come from.
    indeed, with Euro wide unemployment expected to breach 10%, where indeed are our inflationary drivers apart from higher taxes and oil price increases – which do not effect Euro Zone members as greatly as the USA.
    This being the case, I’d have to opine that deflation, as with the UK, is a reality unless the Euro goes through the roof as far as the US$ is concerned, which will be a double edged sword. Still the ECB has some movement left on interest rates to try and kick start the economy, which one though – there actually is the question?

  6. I will try to sum this up with a question(s).

    Should central bankers use DEBT (future demand) to prevent price deflation from productivity and cheap labor free trade agreements/legal immigration/illegal immigration? Is there a better way?

  7. Why do smart people such as yourself, Krugman or Stiglitz not hold senior positions? To put it another way, why do seemingly incompetent people hold crucial positions within governments worldwide?

    P.S. I understand you were head of the IMF, but only for a year and Stiglitz was in the Clinton administration. Both were periods of relative calm.

  8. I dont think that de- flation is bad for all it is only a problem when it is to quick. I say let it be.

  9. I have a few ideas maybe others would respond to on the above – I am looking for honest comments and not flippant rebuttals. Unfortunately, I will not be able to comment back until later tonight.

    Japan’s lost decade seems to have been a precursor to a decline in their own population. It was their exports, which help bring them out. Germany is now experiencing that same decline and Eastern Europe is/has been also in that decline never really having a sustained baby boom after WWII. Could part of what we are experiencing in terms of economic decline be based on an aging population in the West? The first case study would be housing in general. We have been having excess housing built for three years without really paying attention to demographics this is true both in the US and Europe. I feel, it has contributed to our economic down turn as wages only let a person own so many houses and using them as investments only works as long as there is need, most seem to be arguing that the prices caused the bubble or even adjustable mortgages. But, I have yet to read a story showing rental property is filling in proportion to the number of houses being foreclosed on both here and in Europe. Yes, there is an increase in homelessness in some areas in the US, I do not know about Europe outside of England where squatting is up, but even that does not seem to reflect the current events in terms of proportion of need. If someone has these numbers, please pass them on and I will revise my thoughts on Western population leveling even with immigration both legal and illegal in the US.

    Next, inflation vs. deflation. (Here I am only going to talk about the US as I have not done enough work on Europe outside of reading the same reports you have mentioned. But my conclusions will work of Europe.)

    I have some concerns here in terms of both inflation and deflation. I have been watching a trend where manufacturing in the US is keeping prices at last year’s prices when commodities were high. They have found they are still making money on less sales of goods and are not willing to let prices decline, but would rather let people go and watch inventories closer, Europe do to its work rules has a harder time doing this I believe; thus we are seeing little deflation and more unemployment in the US. The deflation seems to be coming from imported goods and hour cut backs at work places in terms of wages. (Time to reintroduce the idea of a 32 -35 hour work week as full-time? – semi joking)

    While my wallet objects, my brain sees companies keeping pre 4Q 2008 and 1st quarter prices as a possible good thing as it encourages purchasing from local vendors who can respond to demand faster then overseas vendors. This should help to stabilize employment and wages for a while, but eventually formulas will be worked out to buy cheaper goods overseas again when demand levels at its new volume. I feel the pressure for inflation will come not from what the government is doing this time, but from countries like China, India, etc. who have the populations, if they choose, to change from a global supplier to an internal supplier of goods and services. Example: Gas and copper for awhile is/was going up currently because of an increase in demand in China while the West has cut back. I hate to be a doom and gloomer, but until China and India’s populations both take a real decline in 50 years, we had better be ready for inflation and it cannot be fought with traditional means. I believe that companies should really think long term and look at pulling vendors home permanently in anticipation of inflation and what could be a weakening dollar under it. If it is done right, there may not be as much inflation as there could be as the dollar should stay strong. Companies also need to look at adding rail into their shipping times as long distance trucking will only add to inflation pressures. As for government policy, we will need to give more loans at low rates to companies that will employ most likely no more than 100 people, so they can be reactive to inventory levels faster as our population ages and purchasing habits reflect older peoples wants.

  10. clearly, the inflation scare is intended to push the stock markets higher. the ‘market’ is a reflection of ‘confidence’ and it creates a self reinforcing circle..the market goes up because consumers are more confident; confidence goes up because the markets are rising.
    this can’t be obvious only to me, can it?
    Problematially for the gov’t is that when the ‘appetite for risk’ that we are hearing barked at us from every corner now, pushes the bond/tresuries yield higher. like they are trying to have it both ways. they seem so desperate to create the illusion of ‘green shoots’ at the moment that they risk it all…so much so they won’t even let the markets correct ‘normally’ for fear they will continue to fall beyond a normal correction as all the ‘traders’ have their hands poised on the sell button to get out first…before the bottom drops out again on the truth that its all illusion, smoke and mirrors.
    to reinflate back to 05-07 levels is on its face rediculous..yet that seems to be the game/hope/plan.
    when does anyone think that actually making real things that people actually need/want might help for a more sustainable future? it seems hardly anyone wants a real change fromthe continued manufacturing of more innovative financial instruments as somehow a healthy realistic export of the USA into the future.
    what is the end game here after all i wonder??
    speculation can only cause inflation scare for so long..then someone actually counts the barrels of oil in storeage and in use and the jig is up. or not.

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