Gonzalo Garland. Professor. IE Business School
1 June 2016
Inflation is no longer the great enemy it was. Now the challenges are driving economic growth, reducing unemployment, and reducing the deficit and public debt. Hence we need to talk about deflation.
If we pause for a moment to look at inflation from a historical perspective, we might be surprised to see how our approach to this particular variable has changed over time. More than four decades have passed since the oil shocks and stagflation—the combination of inflation and stagnation that first appeared in the 1970s—meant that price rises were the main concern of governments around the world. Reflecting this concern, the main economic debate of the time was whether to prioritize by trying to tame inflation or to focus on beating unemployment. The early polices of Margaret Thatcher and Ronald Reagan in the 1980s saw inflation as the greater menace.
Most countries in Latin America also saw inflation as their main problem in the wake of the foreign debt crisis that hit in 1982, and carried on doing so right up until the mid-1990s, when they stopped printing money to finance public deficits, in large part because the debt crisis itself made it impossible to finance deficits through further debt, internal or external. This reality later spread to other countries in the world, such as Zimbabwe for example, which eventually had to abandon its own currency to try to rein in hyperinflation.
So it’s safe to say that for much of the last few decades, economists have seen inflation as the main enemy. But the world has changed over that time. If we look at the inflation data in many industrialized countries, we could say that if there is a problem with prices today, it’s more to do with deflation.
Prices fell in the United States during the first five months of 2015, and it has only been in recent months that inflation has begun to creep up again. In Europe, year-on-year inflation is 0.3% according to the data from January of this year, while the preliminary data for February is -0.2%. On a country by country basis, the figure is 0.3% for the United Kingdom and France, and 0.4% for Italy and Germany, 0.4% for Spain, and in Switzerland, outside the euro and the EU, the figure is -1.5%. Levels in the Eurozone range from the lowest level of inflation of -1.5% in Romania, to 1.8% in Belgium. There are many different reasons for these low inflation levels, and without doubt, recent low oil prices is one of them.
Japan has been setting the trend for low or negative inflation for almost two decades. Before the great recession of the last five years, we had become used to Japanese deflation, even if we saw it as something strange and foreign, something unlikely to affect us. But just like trends in our pensions systems, in Europe especially, and in the United States to a lesser degree, similarities to what was happening in Japan began to appear. We will need to be alert to further advanced warnings from Japan as to what might happen in Europe and the United States.
Almost without realizing it, we have transitioned from a time when our main concern was inflation to one in which we are more worried about economic growth, unemployment, and managing deficits and public debt, particularly in the industrialized countries. That said, price rises remain a concern. Inflation is still a problem in some countries in Latin America, such as Venezuela, Brazil and Argentina, but in the industrialized countries, the real threat now comes from deflation.
Once again, as Japan has shown, deflation is dangerous, in part because falling prices means that waiting longer to buy something becomes an option. Why buy something today if you know it will be cheaper in a few months time? And if consumption falls, the economy slows down. At the same time, falling prices put pressure on companies’ profits. When inflation rises, what usually happens is that companies raise prices in line with their higher costs, in the same way that wages go up. But when prices fall, then companies have to sell things more cheaply, even though it’s not easy to lower wages. If prices fall without reducing salary costs, profits are hit.
At the same time, the debt burden increases, because it costs more to produce enough to pay for things whose nominal value remains the same. At the same time, when prices fall, new savings alternatives appear. For example, although a bond pays little, 2 percent for example, if prices fall by 2 percent the return is effectively 4 percent, which in the current climate is attractive. The problem is that such a scenario doesn't encourage people to spend money which would increase demand.
The fight against deflation is now the priority for a growing number of countries. In Japan, for example, one of the main objectives of the country’s economic policies, known as Abenomics after Prime Minister Shinzo Abe, is to move the country toward inflation. At the same time, the European Central Bank is still far from achieving its goal of keeping inflation near, but below, 2 percent. And that is why the majority of analysts believe that the ECB still has significant room for maneuver before achieving that goal. It will be interesting to how oil prices evolve, but everything suggests that we will be seeing unconventional monetary policies for some time. Which probably means that what was once unconventional will soon become conventional. Something that was once strange to us has become familiar. Times have changed.