Deflation

The European continent is now plagued with deflation and it is further evidence that the medicine, loose monetary policy, isn't working-in fact the patient appears to be getting sicker.

Already seven countries in Europe are now in a deflation, Bulgaria-1.4%, Greece -1.1%, Spain-0.3%, Italy-0.1%, Hungry-0.5%, Slovenia-0.1%, Slovakia -0.1%. Additionally, there are now four other countries where the inflation rate is zero percent; they include Cyprus, Lithuania, Sweden and Portugal. The EU average inflation rate is 0.4%.

Deflation means that prices for goods and services are falling in the economy and is the inverse of inflation, which means rising prices.

But why are economists getting hot under the collar about deflation? After all , falling prices for goods and services means that consumers have more change in their pockets, which means that they go out and spend more, which in turn is a boost for the economy. Surely that is a good thing. So what is the problem? Well, that is partly true depending on what type of deflation the economy is experiencing.

There are two types of deflation. For example, when deflation is brought about by a fall in technology prices, such as computers and mobiles becoming cheaper, it can lead to productive gains in the economy. Consumers will have more change in their pocket to spend on other items. This type of deflation, as described above, is beneficial for the economy. Regretfully, this is not the type of deflation European economies are currently experiencing.

Falling real incomes have resulted in a sluggish aggregate demand in the economy. Producers, retailers and service providers have responded by discounting the prices of their products or services. As reported in Reuters in an article dated in May 2014, entitled, “Carrefour in front line as French retail price war heats up.” The article goes on to to say that Carrefour is in the front line of a French retail price war that is showing signs of becoming bloodier than expected as supermarkets scrap for market share in a sluggish economic recovery.

"The price battle will be tough in the second half of 2014 due to a still tense consumption climate. As Carrefour regains market share, Leclerc and Auchan have become more restless", said Yves Marin, senior manager at the Kurt Salmon consultancy.

French consumer confidence fell unexpectedly in April as debt-burdened households grew more wary about their deteriorating finances and high unemployment, according to the official data.

Auchan, another major retail group, has now joined the fray, cutting prices in March by up to 5 percent and making clear its determination to continue.

"The price war is continuing. We will not be the first ones to end it," Phillipe Courbois, head of client relations for Auchan France, told Reuters by phone.

So with severe price wars that start in the first and second quarter of 2014 in almost every sector it is no surprise then that we are seeing deflation figures currently in many countries today in Europe.

This type of deflation is concerning, particularly when consumers are put off from spending today. Why make that purchase now, when the product or service is likely to be cheaper sometime in the future? So consumption is deferred for a later date. Furthermore, businesses might be detered from making investments to ramp up production in an environment of falling prices, which translates to falling profits. With business investment put off, it can be a drag on employment, which leads to falling aggregate demand and then falling price. The viscous cycle of falling prices, consumption and investment, continues until the economy eats itself which is exactly the type of deflation that economists are worried about in Europe.

However, what is more perplexing is that the European Central Bank (ECB) is proposing to tackle the problem of deflation by carrying out pretty much more of the same policy that it’s been carrying out since the beginning of the 2008 financial crisis.

Indeed, the solution that the ECB proposes is more quantitative easing, which means purchasing bonds with the aim of keeping interest rates low and pumping billions of dollars into the economy.

But pumping the economies with liquidity (money) is unlikely to solve Europe's economic woes. After all, what happens to the money supply is irrelevant. What really matters is the level of investment in the economy. If private investment has gone on strike, so to speak, then public investment should step in financing large infrastructure projects with the aim of boosting employment and aggregate demand.

But what’s being suggested is nothing new. It was said years ago by the esteemed economist John Maynard Keynes, who basically suggested that the money supply is irrelevant. When the economy has been derailed, what really matters is capex, businesses investing in fixed assets, plant and machinery and public expenditure on large scale infrastructure projects

Nevertheless, we see ECB doing what it did previously, purchasing billions of US dollars of Italian and Spanish bonds to keep them stable, which happened to be an identical policy followed up its counterpart across the pond, the Federal Reserve (FED).

In an article in Bloomberge entitled “U.S. Stocks Rebound With Crude as Treasuries Drop on Fed”, October 16, the market rebounded from the recent sell off due to news from a Federal Reserve official that the central bank should consider delaying the end of stimulus plans (85 billion dollar plan of monthly bond purchases since January). The market responded as usual. Equities jumped, Treasuries fell and oil price recovered. Again we see the central bank “call trade”, making profits for traders. Maybe its a no brainer. Wait for the market to tank, then place a bet that the central bank will respond with more QE and bank the profits the next day.

But what has changed in the real economy?....