Stephen Kinsella

Friday 1 August 2014

Why deflation would be a disaster for this country if it took hold

Stephen Kinsella

Published 08/04/2014|02:30

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It's expected that ECB President Mario Draghi will announce a reduction in the interest rate in June

Everyone remembers when the money they had bought them more stuff. I know I do. When I was a kid, two groats and a halfpenny would buy a Curly Wurly the size of your arm. Honestly, now look at the price, and the size of them.

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My faulty memory aside, inflation is a general rise in the price level, which erodes your ability to purchase goods and services with your cash. So if you had €10 and every apple was €1 yesterday, you could buy 10 of them. If the price goes up to €2 per apple, you can only buy five of them. Inflation hurts people on fixed incomes like the old and the poor, but it also makes Irish goods less competitive when they are exported abroad, and makes it harder for businesses to plan ahead effectively.

Crucially for Ireland, when interest rates are low, inflation is an implicit transfer from lenders to borrowers because the borrowers are paying back loans in 'cheaper' money.

Deflation is the opposite of inflation; it is a sustained fall in the price level. There are real fears we will see deflation across the eurozone. Consumer prices are now falling in Cyprus, Greece and now Spain, and are near zero in almost every other country, including Ireland, where the year-on-year change was -0.1pc last month.

You might think 'yes, yes! cheaper stuff!', and you'd be right to think that way, at least at first. As ECB President Mario Draghi said recently, when the price of things falls, people buy more of those things. That is, unless people expect prices to fall further. Once people expect prices to fall further, then they don't purchase goods, services and large durables like cars and appliances right now, which leads to lower cash flows and profits for firms, who have to fire people or not take anybody else on, and this leads to higher than expected levels of unemployment, which leads to lower spending on goods and services, an increase in inventories across the board, which causes further decreases in prices as firms put their goods on sale.

General falls in the price level don't just affect apples, they affect property prices and, crucially for Ireland, debt and debt repayment levels, because just as inflation carries an implicit transfer from lenders to borrowers, so deflation carries the reverse transfer: borrowers are paying back more than they borrowed.

In an economy like Ireland, the ratio of household debt to disposable income is about 196pc, while the UK's debt to disposable income is about 140pc, and in the US it is about 120pc. Any large negative change to Ireland's general price level might have a catastrophic effect on our housing markets, but also on economic growth and the repayment of our debts.

Ireland's SMEs have historically high debt levels at the moment, too, as highlighted recently by UCD's Prof Morgan Kelly.

At last week's press conference, Dr Draghi said the ECB expected "a prolonged period of low inflation" before a gradual recovery. Core interest rates are as low as they can realistically go. This is risky.

Another strategy involves so-called quantitative easing, where the central bank creates money, buys bonds and injects liquidity into the system, which is very good for stock markets and other financial intermediaries, but of much lower benefit to the real economy.

For a tiny country like Ireland, which is part of a monetary union, deflation across the eurozone would be a disaster if it took hold, as it has in Japan for more than 20 years. The new policy of Abenomics, which invokes the Japanese central bank trying to spend its way out of the crisis, looks like it is working, at least in the short term.

For Dr Draghi to consider using an expansion of the European Central Bank's balance sheet to combat deflation, things would have to get a bit worse. Despite the poor inflation data, an argument could be made that what we are seeing is a 'disinflation' rather than an outright 'deflation', and that is the one the ECB is listening to at the moment. Inaction is generally a good thing as a central bank. You can generally get away with using nice, cheap words if you have the credibility. And no one has more credibility to spend than Mario Draghi.

As it has so many times in the recent past, Europe's fate may rest on the decisions Dr Draghi takes in the next few months.

STEPHEN KINSELLA IS A SENIOR LECTURER IN ECONOMICS, UNIVERSITY OF LIMERICK

Irish Independent

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