Deflation Fears in the Euro Area are Overstated

Deflation is defined as a general decrease of the price level. There have been several such episodes in history, for example the U.S. experience during the Great Depression, and Japan after its housing bubble burst in the early 1990s.

But, isn’t a decrease in prices a good thing?

Why do people worry about deflation? Isn’t a decrease in prices a good thing? Well, there are some theories about why deflation might be bad. Economist Irving Fisher (1867-1947) thought that the Great Depression was exacerbated by deflation.

If the price level falls, debt contracts become more expensive in real terms, and therefore more difficult to repay, leading to defaults, and eventually to a drop in consumption, a recession, and even more deflation. Also, if prices are expected to fall, consumers may wish to postpone their consumption, adding to the drop in consumption.

I think deflation fears are overstated. First of all, it is not clear that deflation is bad . Economic theory does not unequivocally say so. In fact, deflation is implied by the optimal monetary policy derived for many economic environments. A frequent result in theoretical economic models is that the Friedman rule , which sets the nominal interest rate at zero, is efficient. Because the nominal interest rate is the sum of the real interest rate and the inflation rate, and because the real interest rate is usually positive, a zero nominal interest rate implies a negative inflation rate—deflation. That is, deflation is actually efficient.

Second, there is no general expectation of deflation at the moment , so the vicious circle in which deflation expectations generate more deflation is not at work. According to the professional forecasters surveyed by the ECB, average inflation expectations over the next years are well above zero. See for yourself. 

Finally, the largest fall in prices is in countries from the Euro area periphery. It is the low, sometimes negative, inflation rate in periphery countries that is lowering the European average. This is a symptom that the real exchange rate is finally adjusting in the European periphery. Without the possibility of nominal devaluations, an inflation rate lower than the average is the only way to get a more competitive real exchange rate .