Tuesday, March 2, 2010

More on Deflation

For those who continue to insist that the combination of large government deficits and large monetary stimulus will inevitably lead to runaway inflation, another story in this morning's Wall Street Journal:

Deflation Threat Is Latest Headache for Euro Zone

FRANKFURT—European countries struggling to plug gaping holes in their state finances face an additional headache: not enough inflation.

A prolonged fall in prices, which economists call deflation, are a real possibility in some euro-zone countries including Spain and Ireland, analysts say. Others, including Greece, face years of very weak inflation. Such an outcome could make it even harder for the euro zone's weakest economies to escape the downturn, and for their governments to repair their budgets and reduce their public debts.

"It's a very strong risk that Spain and Ireland will face a very long period of deflation," as collapsing housing bubbles continue to ripple through their economies, says Jennifer McKeown, economist at London consultancy Capital Economics.


The combination of high debt and falling prices on the once fast-growing fringe of the euro zone would complicate hopes for a wider recovery in the euro zone. Spain and other countries on the bloc's periphery have been a key driver of the region's growth in the past decade.

Purchasing-manager surveys released Monday showed manufacturers in Spain, Greece and Ireland cut selling prices last month, continuing a trend in place for well over one year. In Greece, they fell at their fastest rate in eight months, "as heavy competition continued to restrain manufacturers' pricing power," according to Markit Economics, which compiles the data. Overalll euro-zone manufacturing output picked up to a 30-month high in February, fueled by exports and domestic restocking.

Consumer prices are already falling in Ireland. They risk doing so in Spain, many economists say, where unemployment is at the highest level in the euro zone. Consumer prices in Ireland are down 2.6% from a year ago, the biggest drop in the euro zone. Irish consumers' spending is in retreat, after the country's recession pushed the jobless rate up by almost two-thirds to over 13% at the end of 2009.

Retailers have responded by slashing prices. Marks and Spencer's "We've listened. We've lowered" campaign in 2009 cut the prices of clothing, furniture and homeware by an average of 12%. Consumer prices are expected to fall again in 2010, according to the European Commission.

For businesses, lower prices of consumer goods and services often mean lower profits. For governments, they mean less tax revenue, especially in European countries where sales or value-added taxes make up a large share of tax receipts. That could complicate the already fragile calculations of Greece, Ireland and others as they try to rein in their budget deficits.

Deflation occurs when falling prices become embedded in the mindsets of households and businesses, causing them to delay spending, investing and hiring because they believe goods, services and labor will cost less in future. Such expectations and the cautious behavior they lead to can trap an economy in a kind of malaise that has gripped Japan for the better part of two decades.

Economists generally agree that a bit of inflation is a good thing: In moderation, rising prices help fill government coffers through greater tax revenues, and can make it easier to pay off public debts by shrinking them as a share of government revenue. More than a little inflation, however, is a menace, most economists and policy makers say, based on bitter experiences like the 1970s, when inflation in many industrialized countries undermined economic growth and employment, and required a painful spell of high interest rates to curtail.

The European Central Bank says it has avoided both inflation and deflation: Annual inflation in the 16-nation euro zone is running at about 1%. The ECB argues that the medium-term expectations for inflation that guide the behavior of businesses, labor, consumers are more important than short-term movements in prices.

ECB President Jean-Claude Trichet cites survey data showing professional forecasters expect inflation to be right around the central bank's target of just below 2% in five years' time.

That's true for the euro zone overall. However, the roughly 20% of the euro zone made up by Portugal, Ireland, Greece and Spain could face much lower inflation than the euro average, and possibly declining prices in coming years, many analysts say.

One reason is that the euro zone's weaker economies need to make their industries more internationally competitive, which may require staff and wage cuts for some years.

Full story link: