EU Deflation Doesn’t Have To Be A Disaster

Now that Europe is officially in deflation, most analysts think that a round of QE from the European Central Bank is almost inevitable, despite German objections. But no matter what the ECB decides later this month, deflation won’t necessarily be the economic catastrophe that some investors fear, and Source head of research Paul Jackson argues that there could be a silver lining.

“From an arithmetic point of view, the Eurozone may be experiencing deflation. However, both theory and practice suggest this does not have to spell disaster,” writes Jackson with Source research assistant Andras Vig. “Falling oil prices and a weakening currency could help the Eurozone rise from the ashes of despair. Wouldn’t that be a surprise?”

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Deflation was common during the gold standard

Jackson argues that deflation used to be a fairly common occurrence. When currencies were tied to the gold standard a bout of inflation had to be followed by deflation because the amount of gold was fixed – new gold could be mined, but it couldn’t be increased at will. Going back to 1291, he shows that Swedish CPI spent nearly as much time negative as positive.

swedish CPI history 0115 EU Deflation

Of course you could also make the opposite argument, that a period of excessive deflation under the gold standard should be followed by inflation for the same reason, but in the age of fiat currencies there’s no obvious reason why either trend ever has to come to an end. As we’ve seen in Japan, a deflationary spiral can be extremely difficult to pull out of.

EU Deflation

Not all deflation has to be destructive, says Jackson

But not every bit of deflation has to end up in a death spiral. Jackson argues that deflation caused by falling input prices (notably oil) shouldn’t be confused with deflation caused by falling demand, and that the former doesn’t have to be so destructive because it could just as easily be seen as putting more money in consumers’ pockets. Besides, tipping into negative isn’t the same as a broad-based reduction in prices, which the ECB says that it still doesn’t expect to see.

“From a financial perspective, it is not obvious that a move in inflation from +0.5% to -0.5% should have any different impact to a move from 5.5% to 4.5% (there is nothing magical above the zero level). Central banks have made a rod for their own backs by convincing everybody that inflation has to be 2%,” he writes.

EU Deflation