Central banks seem to be keen on avoiding deflation at any costs but inflation for its own sake is likely to be worse
Inflation is on the retreat in much of the world giving rise to concerns about deflation. Economic theory along with the experiences of Japan makes deflation one of the most feared outcomes in economics. The central bank in Japan is planning to double its money supply as part of its battle to end deflation while the European Central Bank cut interest rates after inflation figures in October were too low for comfort. The fears about deflation have resulted in policies which suggest that inflation in any form is better than deflation. But deflation is a symptom of bigger problems and the prescribed cure may do more harm than good.
Economics textbooks paint a grim picture when it comes to deflation – lower prices translate to less money to pay off debts for both businesses and governments with consumers holding off on purchases if today’s prices are likely to be lower tomorrow. Japan has been a case study of the damage done by deflation –the bursting of a gigantic financial bubble in 1989 resulted in around two decades of falling prices seen as sapping the life out of the Japanese economy while government debt has reached around 230% of GDP. The years of deflation reinforced the notion of deflation feeding upon itself to reduce demand for goods and services and further drive down prices.
However, according to this rationale, deflation is the cause of the problem rather than simply a sign of a sluggish economy. The reasons behind deflation are based on prices being too high as a result of unsustainable price increases in the past. We can see an example of how this works in that stock prices in Japan are still less than half their peak value, highlighting the extent to which prices can be massively overinflated. Prices for consumer goods are not subject to the same price pressures as in the stock market but the example illustrates the consequences of economic overheating.
There are parts of Europe with similar issues but nowhere is close to being on the same scale. So, while Japan shows what can happen, its relevance to Europe is likely to be limited. The deflation emerging in Europe, such as in Greece and Spain, is the result of weak demand coupled with falling wages which helps businesses by lower their costs. The lower wages are needed for these countries to regain their competitiveness relative to the rest of Europe as other options, such as currency devaluation, are not available for countries in the Eurozone.
The response of central banks in Japan and Europe has been to use monetary policy to weaken their respective currencies but this targets the symptom and not the problem. A weaker currency increases the price of imports and is tantamount to paying foreigners more to buy stuff just to create inflation for its own sake. However, higher prices are more likely to result in consumers tightening their belts as their purchasing power diminishes. The idea that low inflation requires more of the same approach misses the fact that these monetary policies bring their own costs with little benefit. Deflation doesn't seem so bad in comparison.