It does not take to be a financial or economic expert to know that the Eurozone is gradually but confidently sliding into deflation. According to Eurostat, in December 2014 inflation has crossed the “red mark” of 0 percent, obtaining a negative value for the first time in quite a while. Why?
The prime reason for this is the falling oil price. With prices of oil that have shrunk by more than half, compared to 2013, production now has become a lot cheaper. This, consequently, pulls the final prices of products down as well. A point that becomes even more obvious, when the value of the so-called “core” inflation is considered (the level of prices excluding prices of food, energy, alcohol and tobacco). Whilst the overall level of inflation is around -0.2%, the level of the core inflation is still above zero, even though only marginally: 0.8% (Eurostat).
In the US the story is pretty much the same. Being seriously dependent on the imports of oil, and to a lesser extent on the prices of goods from Europe, the economists from the Fed should really get their heads round the problem. With the oil imports accounting for 7.8 per cent of all the imports, such a severe plummet in prices could not leave the levels of inflation unchanged.
The question is: why deflation is bad at all? At first glance lower prices, given the same income, mean increased purchasing power, which is certainly not a bad thing at all. The only amendment here: if deflation does persist. However, when inflation is below zero for a considerable period of time, the constantly falling prices push people towards consuming less today, because tomorrow prices will be even lower still. This sets consumption down, which in turn damps GDP, and it goes all over again, until the equilibrium is reached at a lower level of output (sounds familiar, right?).
Also, deflation affects lenders and borrowers. If you borrow 100 EUR today, and have to return it in a year, the person who lent it to you will certainly be happy about some level of deflation (because then, 100 EUR in a year would be worth more than they do now). Clearly, though, you would not share the happiness of that person all that much. If you take it to a broader scale, debtors might end up in a serious trouble (yes-yes, Greeks probably do not like deflation very much, but it has to be said that inflation would not solve their problems, either)
At this point, every SSE Riga student can infer that if the prices are too low, why not inject more money in the economy? Apparently, chaps at the ECB must have thought of the same thing. They are now planning to inject 60 bln EUR every month from March 2015 to September 2016 by buying Eurobonds. They do that, but at the same time they still remain very cautious about it. Firstly, it might result in an unfair distribution of money in the society. Secondly, it reveals the biggest issue of low inflation: the liquidity trap.
As we all know thanks to Morten, the liquidity trap is a situation in the economy, when the government tries to increase the monetary supply, pinning hopes that it will decrease the interest rates and boost investments, but due to the fact that the interest rates are low already, the target is not actually met.
Here we need to introduce the notion of the real interest rates. The real interest rates are the nominal rates less inflation (this relationship is often referred to as the Fisher equation, after a famous American economist Irving Fisher). They show the real interest that people can expect on their saving, excluding the impact of inflation. When inflation is low (or indeed negative), the banking system cannot push the real rates low enough to stimulate investments, because the nominal rates cannot go below 0 (otherwise people would have to pay for saving, which is of course ridiculous).
With all this in mind, it seems that trying to battle deflation with monetary policy measures is not something that is capable of turning the Eurozone to its former prosperity. For a moment it looks like the fiscal policy measures could cope with the job better (anti-austerity measures, etc.)
After all, when most of the European countries have managed to cope with the economic pique of 2008-2009 maybe it is time to go further? This would mean increasing government spending, reducing taxes and trying to defibrillate the suffocating economy in the good old ways.
Why nobody does that? There are many possible explanations. To put it short, the reason most likely stems from political and geopolitical situation. Because when the world is on the brink of maintaining social stability, fighting wars, suffering from terrorists, and battling social inequality, nobody is willing to take their chances.
