Deflation is bad. Just ask Japan. First, by creating expectations that prices will be lower next year it gives consumers incentives to postpone purchases.As a result, aggregate demand declines putting further downward pressure on prices. Second, since private and public debts are fixed nominally, declining prices increase the real burden of the debt. Put differently, as prices decline government and private revenues decline while the service of the debt remains unchanged. This forces the private and public sectors to spend an increasing proportion of revenues to service the debt, forcing them to cut back their spending on goods and services. This in turn increases the intensity of the deflationary process. This is probably the most important negative effect of deflation.

Are these risks becoming a reality in the euro zone? The consumption-postponement effect is not yet operative. Prices are still increasing in the euro zone. Only if consumers actually expect prices to decline will it start operating. The second effect, the debt-deflation dynamics, however, is already working. It is important to stress that this effect does not crucially depend on inflation being negative. It starts operating when inflation is lower than the rate of inflation that was expected when debt contracts were made. Thus, during the last ten years inflation expectations in the euro zone have been very close to 2%, which was also the average rate of inflation during that period. Current nominal interest rates on long-term bonds reflect the expectation that inflation will be 2% for the next five to ten years.

Inflation in the euro zone has been declining since early last year and now stands at 0.8%. This disinflation exerts debt-deflation dynamics. The nominal debt increases with the nominal rate of interest (which includes a 2% inflation expectation), but the nominal income in the euro zone increases by only 0.8%. As a result, an increasing proportion of these revenues must be spent on the service of the debt. Less is left over to spend on goods and services. Thus, the euro zone as a whole already suffers from debt-deflation dynamics. It is not yet catastrophically intense, but surely it should be stopped before it gets worse when inflation turns negative.

Moreover, there is a tug-of-war starting between the euro zone and emerging markets (EMs). As American output and interest rates rise, capital outflows in one or both regions are likely to rise. What form these outflows will take, which region will suffer more, depends on each region’s financial vulnerabilities, and how their politicians are expected to operate under duress. That is, the main game that will be played now in capital markets. It resembles a tug-of-war because the effect of American economic recovery may greatly depend on the relative strengths of these regions. If the balance tilts against the euro zone, investors will shift the composition of their portfolios and deteriorate its credit channel. Whether or not this triggers deflation of euro-zone prices depends on the role of euro-denominated assets for collateral and in facilitating commercial transactions.

However, the euro area is a large currency zone where the euro is well-established as a unit of account, and a central bank which is strongly averse to inflation; therefore, the “flight to quality” may produce opposite effects, namely, strengthening of the euro and price deflation. This moght not be good at all for the euro-zone real sector because, to the weaker competitive conditions triggered by currency appreciation, price deflation may add two lethal factors: (1) debt deflation (A situation in which the collateral used to secure a loan decreases in value), and (2) the expectation that prices will continue falling. Factor (1) further dries up credit flows, while factor (2) increases the real return of cash balances and, hence, lowers aggregate demand. A major flight- to-quality episode would call for further relaxation of ECB credit, which is likely to meet major opposition in its board.

Moreover, EM banks have been largely free from “toxic assets” and can better fend for themselves than euro-zone banks that so far have survived partly due to the ECB help. Thus, if the ECB falters in coming to their rescue in a new flight-to-quality episode, their chances of surviving are bleak compared to EM banks. Moreover, despite their dysfunctionality as a trade or currency union, some key EMs (notably in the Middle East, Africa and Latin America) are resource-rich, and they still have vast expanses of unexploited resources. These areas will benefit from continued growth in China, while for the euro zone it may signify stiffer industrial competition from abroad.

Inflation in the United States followed a pattern similar to the euro zone between the end of 2009 and the end of 2010. After observing a few months of declining inflation readings, the Federal Reserve started to act. Firstly, in August 2010, the Federal Open Market Committee (FOMC) announced the reinvestment of principal payments from agency debt and mortgage-backed securities purchased during the first round of Large Scale Asset Purchases (LSAP). Secondly, in September of the same year, the FOMC statement introduced the first instance of post-crisis forward guidance language (“economic conditions are likely to warrant exceptionally low levels for the federal funds rate for an extended period.”). Thirdly, in November, the Committee announced the second LSAP program for $600 billion. While other factors may have played an important role, both headline and core inflation measures did bottom out between November and December 2010 and reverted back close to the 2% target within the next six months.

So, may be the time ripe for the ECB to follow in the Fed’s footsteps and become more aggressive against low inflation. but the ECB is unlikely to embark in quantitative easing, due to the Bundesbank’s concern about blurring the line between monetary and fiscal policy. The ECB is paralysed by internal dissension that prevents it from increasing liquidity in the system, the only sure way to prevent deflation.

At the moment, the risk of deflation for the euro zone is real. America lived through a similar experience in the recent past. The Federal Reserve ramped up its response, with a number of unconventional policy actions. Perhaps, now is the time that Europe moves one step beyond what America has done and experiments with more aggressive policy actions.

The above has been compiled  from an on going debate on Deflation in the euro zone in the Economist.

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