Features

How to fight Europe’s demons of deflation

It’s a real problem, but the answer has less to do with bond-buying than with applied psychology

22 November 2014

9:00 AM

22 November 2014

9:00 AM

Deflation terrifies economists because once it starts, they have no idea what to do about it. When demand in an economy shrinks, companies cut jobs, and with fewer employed demand shrinks even more. The deflationary spiral is self-reinforcing. Central banks can cut interest rates to near zero and slosh money around like drunken lottery winners, but once hope flickers and dies, there is nothing they can do to persuade anyone to invest in the economy. Deflation took hold in Japan in the early 1990s and despite the government straining every sinew, its economy is still ailing 20 years on.

Europe is right, then, to be in a panic. Inflation across the eurozone is just 0.4 per cent and over the past year eight of its economies, including Greece, Hungary, Sweden and Poland, have recorded annualised rates of negative inflation, falls in wages and prices of a kind Britain has not seen since 1960. If these rates persist, we may well be in ‘last-chance Europe’, as Jean-Claude Juncker described it last month before becoming President of the European Commission. A great chunk of the eurozone risks the Japanese curse, an economic malaise which lasts a generation. Britain’s economy and inflation rate may seem the healthiest in Europe, but that could easily change if its neighbours tip into persistent deflation.

Mario Draghi, President of the European Central Bank, said last year that he had studied Japan’s experience of deflation and decided that the EU was not at risk of suffering a similar fate. Recent months have changed his mind. The ECB said this week that it was ready to fire a trillion euros into the EU’s financial system, by buying both government and private bonds. Or was it a gazillion? After so much quantitative easing around the world in recent years, it is hard to keep count.

The Germans are sweating, as they tend to, caught between their prim attitude to credit and a need to keep the eurozone together. They have the ECB just where they wanted it, in terms of geography — in Frankfurt — but that has not meant control. The notion of unleashing a fire-hose of ECB cash -horrifies Berlin: a German lawsuit opposing the ECB’s bond-buying programme is still rumbling through the European Court of Justice. But they may have no choice. An uneasy consensus is forming that preventing deflation is far easier than trying to cure it.


There is another way of thinking about the problem. In 1981, as the Conservative government prepared to give the economy a hard pruning, Lord Hailsham spooked Margaret Thatcher by comparing her plans to those used by Herbert Hoover after the 1929 Wall Street Crash. Hoover’s austerity, Hailsham said, sparked the Great Depression. Franklin Roosevelt’s spending pulled America out of it. Hailsham turned out to be wrong: the 1981 budget cleared the underbrush and made way for the Thatcher boom. But he was right to say that political economics is above all ‘applied psychology’. Give people a strong sense of a sunny future and they will follow you. Dither or depress them and you’re toast.

The underlying problem with Europe’s stalled economy is not German intransigence or Greek profligacy or Portuguese cluelessness, or even a shortage in the money supply. There is plenty of money around, it is just stuck in banks which have been required to tighten their lending standards and improve their capital structures. The larger problem is demographics. Since the crash of 2008, a wartime mentality has taken hold in much of Europe. Even interest rates of near zero cannot persuade people to spend or borrow, for fear that tomorrow something worse will happen. Those with money, who tend to be older, are hoarding what they have and depriving the young of jobs and hope, just as they have done for years in Japan. In terms of ‘applied psychology’, inflation and deflation are superficially equivalent to optimism and pessimism in an economy. But the reason economists hold these forces in such awe is that they redistribute wealth between generations more powerfully than any tax.

The economist and writer Felix Martin likes to explain this with a story about his mother and her sisters. When they gather, they will often ask the question ‘what happened to our father’s money?’ He had retired in 1970, after an accomplished career in New Zealand, with what appeared to be a handsome pile of pension and other savings. For the next decade, he lived fairly modestly, but by 1980 he was anything but well off. The Bernie Madoff character who cleared out his savings was an inflation rate which veered between 10 and 20 per cent. Meanwhile, Martin’s parents had been able to take a teacher’s salary, borrow from the bank, buy a house in Oxford and watch inflation quickly erase their mortgage while their house soared in value. The 1970s robbed creditors and savers and rewarded borrowers. It redistributed wealth from the old to the young, which is precisely what now needs to happen across Europe and why one generation craves it and another fears it.

Europe’s savers, its cash-rich, its Germans, would much rather a brush with deflation than see what they have eroded by inflation. They dress up their fear in dubious virtue, and slap the bottoms of debtors. But if structural reforms mean growth, and growth means inflation, they would rather keep the status quo. The young, those trying to buy a house, the Greeks, want to load up on debts to get their lives under way, helped along by an inflationary economy. But they cannot catch a break.

There is a generational war breaking out in Europe, as well as a political war between countries. You can see it in the many young people supporting Beppe Grillo in Italy and Greece’s Syriza party. In that single, desultory number, 0.4 per cent inflation, lies proof that the continent is socially, psychologically, politically and economically stuck. When that number turns negative, it will further ram home the point.

The answer is more likely to lie in Hailsham’s applied psychology than in the ECB’s coffers. The countries which have been beaten up for the past six years need fresh leadership capable of cheering them up, of seeing the problem in terms of human beings, not just as economic. Someone needs to relieve Spain and Portugal of their tight German-made corsets, dress them in baggy linen trousers, give them a cheap cigar and tell them they are marvellous and that everything will be okay. There are alternatives to this one-way ticket to deflation hell. Before the euro, the baggy linen trousers and cigar route was called devaluation. That’s not an option now, but give a fracturing Europe many more months of this misery and it soon could be.

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Show comments
  • GenJackRipper

    Sweden isn’t part of the eurozone.

    So… Anyhow.

  • Ridiculous. The southern tier has run out of other peoples money to be generous with. If only this german shopkeepers would work 80 HOURS A WEEK instead of 70, those Greek bureaucrats could retire at full pay 5 years sooner.

    Screw Europe: it is financially, morally, intellectually and militarily bankrupt.

    • McQueue

      Screw the currency union, you mean?

      • No, screw EUROPE…not just its ridiculous union. They have been feeding at the hog trough of the US defense umbrella for far far too long. Either they start paying for their own defense or the US should just cancel the relevant portion of the US foreign debt, dollar for dollar. Take THAT, Mary, Queen of Scots.

        • McQueue

          Cool, except don’t understand the Mary Queen of Scots comment.

          • Google “Mary Queen of Scots” skit under Monte Python, the british humor group.

  • greggf

    Your article seems somewhat confused about both deflation and the solutions.
    You fail to look at what’s happening in Japan which is ahead of us by some 2 decades, has already tried your solutions and one you haven’t mentioned – electing a new government!

    Deflation is a monetary phenomenon unlikely to be affected by government policy because governments by default are always working to cause its opposite, inflation.
    Deflation is where the consumer gets payback for all the years of depreciating value of wages, incomes and currencies.

    In Japan all sectors of consumers are saving their purchases until next year or whenever. Assets fall in value; Bonds also fall as interest rates rise but the capital value will still buy the same goods because prices fall concomitantly, and income from Bonds remains real.
    For once cash is king for young, old and retired.
    And, refreshingly, it promises deep change for governments who, like Japan, will cease to be able to rule like today and yesterday.

  • davidofkent

    ‘Those with money, who tend to be older, are hoarding what they have and depriving the young of jobs and hope…’. I doubt that that is true. The fact is that when you get older, you have fewer wants to encourage youthful profligacy. Older, wealthier, people will almost certainly be helping their offspring with home deposits, new cars and unpaid child-minding. The big problem with deflation is that borrowers will not be able to rely on artificial means of shrinking their debt. The good thing about deflation, however, is that the cost of living falls. Thus there should be more disposable income to spend on things that so obsess the young. Obviously, we older people like the idea of deflation, having lived through several periods of very high inflation that robbed us, at the time, of our income and savings. ‘Every cloud …’ , as they say!!!

  • BigCheddar

    I wonder if future generations will view the period we are living through as a rebalancing following decades or more of financial policy meddling. Perhaps we are seeing wages, prices and currencies balancing out globally as poorer nations get richer and the western industrialised nations wealth reduces. Maybe deflation will be part of a ‘correction’ following decades of meddling through monetary policy. I wonder if the conclusion will be that the more we interfere the more disruption we create and perhaps it’s less intervention we need not more?

  • David Brown

    I’m not sure that old versus young is the key difference inasmuch as the young also benefit from deflation. Over the next forty years populations will decline across many EEC countries, hence housing values will decline and the young will be able to buy homes at more affordable prices. The distinction between young and old can be replaced with the difference between government and the private sector. The former are loaded with debt, both direct and indirect through unfunded entitlements, while they have maxed out revenues with high tax rates. They have nowhere to go but to try and inflate away their liabilities. This is a clear case of governments following economic/monetary policies that benefit that institution at the expense of the public.

  • MrJones

    Mass low-skilled immigration is deflationary (cos downward pressure on wages combined with upward pressure on living costs -> reduced disposable income)

    Debt-based consumption is deflationary in the long term (after the short term sugar rush) cos disposable income minus debt repayments -> reduced disposable income.

    It’s obvious and not complicated.

    Unfortunately on the other side of the argument are oligarchs and their lobbyists with briefcases full of persuasive folding arguments.

    • berosos_bubos

      So if I borrow money and my house goes up in value that is not deflationary.

    • Shella Staten Morris

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      healing portion, which he wanted me to take for days, and after which i
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  • Please, please, please leave this Keynesian nonsense to the “Economist” magazine. Gradually falling prices are NOT a bad thing (a sudden crash, as a credit-money bubble bursts, is a bad thing – but prices gradually falling over time as we find better ways to do things, is exactly what should happen). And “monetary and fiscal stimulus” is nonsense, indeed it is nonsense on stilts. Creating money and spending it is not the way to prosperity – Keynes was just wrong. Please look beyond the rubbish you were taught in university and read a decent book on economics – such as “Human Action” by Ludwig Von Mises, or “Where Keynes Went Wrong” by Hunter Lewis.

    • paulthorgan

      I am afraid that there does seem to be historical evidence for the destructive powers of deflation.

      You are just arguing that inflation is more destructive. The important difference is that deflation slows economic activity whereas inflation seems to do the opposite. 1923 may have been bad for Germany, but at least people were being paid, just in increasingly worthless currency. Europe should not have to be bound by the German experience of 1919-1939.

  • you_kid

    I am amazed how cheap food has become in Britain.
    Is it to combat or disguise the need for food banks?

    Homes on the other hand are free – so there is no reason why we shouldn’t blow the lid of those prices.

  • Ed  

    Throughout the article, you discuss in great depth the differences between the economies and cultures of different parts of Europe. You then proceed to prance delicately around the 800 lb gorilla riding the elephant in the living room.

    Obviously, the Euro needs to be split back up into its constituent currencies. Obviously.

    How you could gather so much evidence for this, and then pearl-clutchingly refuse to discuss it, is quite amazing.

  • tomgreaves

    If the euro is to survive there are huge structural changes required in the southern states such as Spain and Italy and Greece. Don’t forget they lived under dictatorships until fairly recent times, and it will take generations for them to rid their cultures of the corruption and criminal mobs that have their thieving fingers in every institution. In Spain, in particular, the corruption reaches into the royals, the central government and in the regions such as Andalucia, there are simply not enough prisons to house the mayors and local government officials who have robbed the public coffers of vast sums of money since records began. It’s no different now. Franco’s Spain is far from being as dead as he is.

    It is not the economy that is so depressing but the powerlessness of the public to fight the mindless social and political structures that strangle all forms of rationalisation and structural change. Trying to do anything in Spain is like pulling teeth. Hopeless inefficiency and dysfunctional systems rule every quarter of life. Forget monetary stimulus, these countries have to go through a prolonged period of self analysis that prevents corruption and brings deep social changes. Putting more money into these places puts more money into personal bank accounts.

  • Roger Hudson

    How are you measuring deflation, against a rapidly ‘inflating’ fiat currency?
    There is so much manipulation, trying to re-inflate the bonkers credit consumption economy , it is difficult to measure anything.
    Having just spent my £200 winter fuel payment on 3 tons of wood pellets for my boiler (great smoke free stuff) I differentiate core essentials inflation/deflation from all the fluff. That ‘digital games’ are in the CPI is a scandal along with much else.

    • Kennybhoy

      “…3 tons of wood pellets…”

      Sound chap!

  • Liberty

    The world has changed. The IT business has seen deflation on an massive scale for decades yet has been the biggest investors and seen the biggest growth of any sector. The reason is the enormous value added by IT products.

    As technology becomes the best way to increase profits, technology becomes IT and develops in power at the same rate as IT, then the added value from technology will become increasingly more important until it is virtually the only thing that counts for wealth creation.

    Using growth itself as a measure of economic success will fall out of fashion because economies will not grow as such, they will shrink as all economic activity becomes automated.

    Deflation will become the norm because as technology replaces workers incomes will fall, demand will fall, prices will fall, force more use of technology forcing fewer workers until most will work part-time, intermittently or not at all and work will not be the defining feature of our lives.

  • Mrs Josephine Hyde-Hartley

    It doesn’t seem to me that inflation and deflation (from the perspective of applied psychology) are the equivalent of optimism and pessimism.

    ..more like inspiration and expiration..you know, like breathing. We can’t have one without the other.

  • “Deflation terrifies economists because once it starts, they have no idea what to do about it.”

    Translated for those not literate in economics or Marxist dialectics…

    “The specter of deflation is used an excuse to reignite central bank credit expansion (via bond buying) so that long-term interest rates will remain low, low interest rates sabotaging large capitalized investments that rely on loans, because the interest rate on the loan, as ultimately determined by the central bank, is too low to cover the large capitalized investment.”

    In fact, deflation is good–and is the preceding step before the blessed recession/depression, where central bank-induced malinvestments are purged from the economic pipeline.

    The Federal Reserve Bank (along with the Bank of England, the European Central Bank and the Bank of Japan) is intentionally maintaining low interest rate policies to prevent the necessary economic correction, which correction would be followed by recovery if interest rates were allowed to rise to their market levels. You see, if interest rates are relatively low, then there is no prospect for net (new) productive investments that require large capitalized loans, since the expected return to the lender (interest) would be too low.The economic sabotage policy the West (and Japan) is experiencing is a by-product of the Marxist co-option of the West’s political parties/institutions.

    The failed socialist inspired and controlled pan-European revolutions that swept the continent in 1848 thought Marxists and socialists a powerful lesson, that lesson being they couldn’t win overtly, so they adopted the tactic of infiltration of the West’s political parties/institutions.

    Notice that not one political party in the West demanded verification of the collapse of the USSR, and the media failed to alert your attention to this fact, including the “alternative” media. When determining whether the “former” USSR is complying with arms control treaties, what does the United States do to confirm compliance? Right, the United States sends into the “former” USSR investigative teams to VERIFY compliance, yet when it’s the fate of the West that’s at stake should the collapse of the USSR be a ruse, what does the United States do to confirm the collapse? Nothing!

    It gets worse–the “freed” Soviets and West also never (1) de-Communized the Soviet Armed Forces of its Communist Party officer corps, which was 90% officered by Communist Party members; and (2) arrested and detained the 6-million vigilantes that assisted the Soviet Union’s Ministry of the Interior and police control the populations of the larger cities during the period of “Perestroika” (1986-1991)!

    The fraudulent “collapse” of the USSR (and East Bloc) couldn’t have been pulled off until both political parties in the United States (and political parties elsewhere in the West) were co-opted by Moscow & Allies, which explains why verification of the “collapse” was never undertaken by the West, such verification being (1) a natural administrative procedure (since the USSR wasn’t occupied by Western military forces); and (2) necessary for the survival of the West. Recall President Reagan’s favorite phrase, “Trust, but verify”.

  • paulthorgan

    I am afraid it will take the kind of political crisis not seen in Europe since the 1930s to cause the currency union to crack. The economy will have to actually off the cliff and in free-fall, there will have to be barricades in the plazas before there is change. There seems to be a virtual Berlin Wall right now.

  • davidofkent

    Deflation – love it. It’s the best thing possible for savers who have been beggared by BoE- and government-induced inflation.

  • Shella Staten Morris

    I Never believed i was ever going to be HIV Negative again,Dr Molemen
    has given me reasons to be happy, i was HIV positive for 2years and all
    the means i tried for treatment was not helpful to me, but when i came
    on the Internet i saw great testimony about Dr on how he was able to
    cure someone from HIV, this person said great things about this man, and
    advice we contact him for any Disease problem that Dr Molemen can be of
    help, well i decided to give him a try, he requested for my information
    which i sent to him, and he told me he was going to prepare for me a
    healing portion, which he wanted me to take for days, and after which i
    should go back to the hospital for check up, well after taking all the
    treatment sent to me by Dr Molemen, i went back to the Hospital for
    check up, and now i have been confirmed HIV Negative, friends you can
    reach Dr Molemen on any treatment for any Disease he is the one only i
    can show you all up to, reach him on
    (drmolemenspiritualtemple@gmail.com) or call him on +2347036013351,
    Facebook page on (https://www.facebook.com/Dr.Mo… Website at (http://drmolemenspiritualtempl…), God Bless you for your Good Work Sire! .

  • CraigET

    “Deflation terrifies economists because once it starts, they have no idea what to do about it. When demand in an economy shrinks, companies cut jobs, and with fewer employed demand shrinks even more. The deflationary spiral is self-reinforcing. ”

    Why is it a bad thing if prices decrease due to lack of demand? Surely a lack of demand signifies that no one wants your product for the price you are charging. If I start a business selling sand to the Bedouins for £10 per kilo, when I go bankrupt, should I blame it on their lack of ‘demand’?

  • Observer

    As it states in the book “Enemies of Europe” on Amazon, the big problem is fair weather friends who were trying to rule Europe without a sense of responsibility. The UK are takers, not givers – it only sought to benefit from Europe in the good days and now it wants to turn it’s back on Europe under extreme leaders like Farage/UKIP. However, these people are leading the UK to a lonely deserted little Island. There is method to the madness in Germany: They don’t try to fix everything with property bubbles – instead, they innovate and form genuine relationships around the world that are mutually beneficial – instead of applying the pirate mentality of short term gains.

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