Deflation vs Inflation

Source: US Bureau of Labor statistics (showing deflation in early 1920s and 1930s)

In the MPC's last monthly inflation report they forecast that inflation could fall to 1%. They even hinted at the possibility of deflation. What is deflation and why does it strike fear into economists and policy makers?

Deflation is simply a fall in the general price level. If this deflation a result of improved productivity and greater efficiency, it could be benign. But, usually deflation is caused by falling demand and lower growth. It is no coincidence that our worst period of deflation was in the great depression of the 1930s. This kind of deflation is very damaging because:

1. Lower Spending. When prices are falling, there is an incentive to delay purchases. Why buy a TV now, when it will be cheaper in 12 months? Look at how the housing market is suffering because of falling prices. Nobody wants to buy with falling house prices; this is why property transactions have slumped and of course causes further falls in prices. In Japan, the decade of deflation created a culture of thrift and saving. Japanese housewives just wouldn't spend. Tax cuts, government spending and interest rate cuts all failed to stimulate growth because all the Japanese wanted to do was save (an example, of the Paradox of thrift)
2. Liquidity Trap. A liquidity trap occurs when lower interest rates fail to stimulate spending. If prices are falling by 2%, it can be more attractive to save money in cash then spend. Therefore, cutting interest rates to 0% may be ineffective in increasing demand.
3. Increasing Burden of Debt. If you take out a mortgage and make mortgage payments of say £500 a month, inflation will progressively reduce the real value of your mortgage interest payments. High inflation thus makes a mortgage more attractive, over time, it increases the disposable income of mortgage owners.

• However, with deflation, this £500 a month becomes a bigger % of your disposable income. In deflation, debt becomes an increasing burden reducing spending and economic growth.

• The problem is that the UK and US are increasingly indebted, personal savings are very low. Personal debt is very high therefore, deflation would be very damaging for an economy burdened with a legacy of debt.
• 4. Rising Real Wages. Workers will general seek to prevent a cut in nominal wages. Therefore, with deflation, real wages rise by stealth. This can lead to real wage unemployment. With deflation, it is much more difficult for prices and wages to adjust.

How To Overcome Deflation.

Basically, Monetary authorities need to implement bold policies. In particular they need to increase inflationary expectations. The problem is Central banks are so used to trying to reduce inflationary expectations, that they can struggle to implement the opposite. However, the experience of Japan in the 1990s and 2000s suggests timid policies can lead to several years of economic stagnation.

• Costs of Inflation
• What is more likely inflation or deflation?
• Questions on deflation

Causes of European Unemployment

Up until the 1970s, the European Union had very low rates of unemployment. It was even referred to as the 'European unemployment miracle' But, after the supply side shocks of the 1970s, unemployment rose and remained stubbornly high until the mid 1990s. There was a slight drop in unemployment during the mid 2000s. But, since the current recession (08-12) unemployment has risen to over 10% - and shows no signs of falling. In some parts of southern Europe, unemployment has exceeded 20%.

What is the Cause of Unemployment in Europe?

Cyclical Unemployment The sharp rise in unemployment since the start of the recession in 2009 reflects the impact of falling demand on jobs and employment.

In particular, attempts at fiscal consolidation without any monetary stimulus have led to the double dip recession and rising unemployment.   (Europe and fiscal consolidation)

Conservatism of ECB. The ECB has a strong reputation for keeping inflation low. The over-riding target of monetary policy is low inflation and arguably this holy grail of low inflation means they are willing to sacrifice growth and investment (e.g. decision to increase interest rates in 2011 because of fears over inflation). It explains the contrast in response to the ECB and Bank of England to the current recession. (Theodore Peligidis 1998 link)

Overvalued Exchange Rate. Some countries in southern Europe, such as Greece, Portugal and Spain have experienced falling competitiveness within the Eurozone. In a single currency, they have been unable to devalue and this has made exports less competitive - leading to lower export demand.

Rigidities in the Euro. The Euro prevents individual countries - cutting interest rates, pursuing quantitative easing and  devaluing currency to improve competitiveness. Another problem is the new fiscal stability pact which places limits on fiscal policy. This gives Eurozone economies few options to pursue higher economic growth.

Supply Side Factors

High Unemployment Benefits. European states tend to have generous welfare benefits which decrease incentive to get a job. However, countries like the Netherlands have seen low unemployment rates despite similar benefit rates.

Labour Market Rigidities. European economies often have generous protection for workers. e.g. hard to hire and fire workers, maximum working week. Protection for trades unions. This gives protection for 'insiders' but not outsiders. It also could explain why European unemployment could be for a longer duration. Within the political systems there is often reluctance to reform labour market policies which protect certain workers at the expense of the unemployed. (Bean 1994)

Skills Based Changes. Factors such as globalisation and increased specialisation have led to rapid changes in demand for skilled workers. The consequence is that unskilled workers have found it more difficult to gain employment. (Lawrence 1994, Krugman 1995, Baldwin and Cain 1997)

Hysteresis. Long term unemployment can make it more difficult for people to find work. Long-term unemployment is rising and also encouraging people to give up and leave the labour force. When we look at inactivity rates, the employment situation looks even worse.

Unemployment is underestimated in the US. US unemployment rates are lower, but arguably there is a higher disguised rate of unemployment including low paid part time jobs.

Conclusion

The more you look into European unemployment the more you realise there is no simple answer. It is unsatisfactory to explain it all away with blaming labour market rigidities and generous welfare benefits. O.J.Blancard (2004) states "High social protection is not inconsistent with low unemployment. However, it must be provided efficiently."
It is also important to consider both demand and supply side policies. The scale of the current EU recession illustrate how the ECB's conservatism in Monetary policy could adversely affect unemployment in both the short term and longer term.
Further Reading

• Causes of Unemployment
• European Unemployment stats

External Links

• Explaining European unemployment
• European Unemployment - myths and realities