Sunday, 12 April 2015

Eurozone: a tale of good deflation

A sudden, unexpected fall in aggregate demand - impacting all sectors of the economy - leaves firms with an excess of inventory. To get rid of it, they are forced to lower prices. However, if for some reason (well understood or not) consumers expect further reduction in prices of goods and services going forward they delay their consumption decisions, leading to even more excess inventory and the need for even lower prices to clear it. Consumers' prophecy becomes self fulfilling. As a result, firms are forced to sell their products below production costs (or at least with much lower profit margins) and their profitability turns negative (or at least falls significantly). Cuts in production and staff ensue. With unemployment rising and consumers' disposal income falling, private consumption and aggregate demand drop further and so do consumer prices and firms profitability. A negative economic spiral is set in motion and an economic depression is the likely outcome.

The logic policy advise is therefore unambiguous: authorities, starting with central banks, should fight deflation with all their might. This is standard economics. And all very sensible.

But what happens when we are faced with a situation where the fall in consumer prices follows an initial across the board cut in salaries in the economy? The cut in firms end-consumer prices will not lead to a deterioration in their profitability as their cost base will have been lowered as a result of the adjustment in labour costs in the first place. The generalised fall in prices of goods and services in the economy (deflation) will in turn partially restore the consumers' lost purchasing power that occurred at the time cuts in salaries took place. Deflation in this case should not delay consumption decisions. On the contrary, consumers should use their partially restored purchasing power to happily spend more. Higher consumption will translate into higher aggregate demand and real economic growth. And given the private consumption's multiplier effect the real economic growth should more than offset deflation and therefore translate into positive nominal growth as well. With nominal GDP increasing debt levels should become more, not less, sustainable.

Putting it differently: the negative impact on consumption, real and nominal GDP, debt sustainability will occur at inception of the salary cuts. It is a negative aggregate demand shock. The subsequent deflation will partially reverse this negative impact. It is a positive aggregate supply shock (as it has lower production costs at its origin). It will lead to more private consumption and economic growth (real and nominal). This is then "good deflation".

The reason why the concept of "good deflation" is absent of standard economics textbooks is simply because when thinking about deflation the mainstream economics' line of reasoning starts with a sudden, out of the blue, fall in aggregate demand. If the whole deflation process is instead triggered by a wide-ranging adjustment in salaries across the economy the concept of "good deflation" is a perfectly realistic one. Or are we saying, for the sake of argument, that after a 50% fall in salaries across the whole economy it is better for aggregate spending purposes that the consumer faces a 5% increase in consumer prices the following year instead of a 20% fall?

Needless to say, I think that the Eurozone is going through a process of (moderate) "good deflation". Could I be wrong?

This question will be easy to answer. If deflation goes hand-in-hand with a fall in retail sales over the next 12 months, I will be wrong. If deflation ends up being accompanied by an increase in retail sales, the idea of "good deflation" will be correct. As of today, the numbers show that Eurozone's deflation set in around December 2014 (-0.2% YoY; followed by -0.6%, -0.3% and -0.1% YoY in January, February and March 2015, respectively). And that retail sales started to pick up significantly in......December 2014 (3.2% YoY; followed by 3.2% and 3.0% in January and February 2015, respectively). The same picture emerges when looking at the Eurozone's peripheral countries data, where deflation set in more intensively and earlier on (in 1H2014. In the case of Greece as early as 1H2013).

So, we can discuss all day long the sense or nonsense of the "good deflation" concept. But for the time being the numbers are on my side. In 12 months time we'll see.

In the meantime, enjoy Mario Draghi's inflation fighting giant QE programme.

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