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Deflation: Menace or Myth?



Japan, as is well known, is in the throes of deflation. The U.S. might be close to it, but the EU? Just a few months ago, Euroland was shaken by vociferous protests against the euro-induced inflation, and now it is said to be on the brink of sliding into deflation, according to most economic media.

Writers are delighted that a new economic term can be explained to their lay audiences: deflation. The horrors of economic contraction are being gleefully explored. In their analyses the old public enemy inflation is suddenly morphing into a benign fellow who supports growth and reduces debts public and private.

The lay audience must be bewildered. After decades of inflation, can't a bit of deflation be beneficial? Japanese consumers are apparently quite happy that prices are finally decreasing.

But is Euroland really faced with the spectre of deflation? There is good reason to doubt that. The current situation is unique in the sense that, for the first time, there is a credibility gap between the official statistics and public perception.

Since the introduction of the euro, national and European statistical offices have consistently told the public that inflation in most countries and Euroland as a whole was very low, in the 1-2 percent range. At the same time, public perception spoke of runaway inflation. Consumer strikes were organized in some countries; telephone hotlines were installed for consumers reporting ‘excessive' price or rate hikes.

A German magazine set up its own consumer price index and arrived at much higher inflation rates than the Eurostat office and their national colleagues. In Italy, trade unions and consumer associations jointly published an ‘independent' consumer price index and calculated that during the first seven months of 2002 the euro currency had already lost almost 4 percent of its purchasing power in Italy. On an annual basis this would amount to an inflation rate of over 7 percent, as compared to the official rate of 2.7 percent (ISTAT, September 2002). By August 2002, the average Italian family had paid up to 1,000 Euro more to cover its daily needs. Average prices for some foodstuffs had increased by 18 percent.

Outdated baskets of goods and services used by ISTAT, the Italian Statistical Office, were blamed for its apparent inability to give adequate weight to the price increases. Also, it turned out that some of the poorest and most inflation-prone regions — Sicily, Campania and Apulia — had been omitted from the national sampling by ISTAT. In other Euroland countries, official inflation rates were still higher, with Spain, Netherlands, Greece and Portugal running above 3 percent, and Ireland at a whopping 4.5 percent (September 2002). Who knows how high the real inflation rates were?

In Germany, most economic editors tenaciously defended the low inflation rates (1.0 percent in September 2002) published by the Federal Office of Statistics. Obviously, belief in the truthfulness of governmental numbers crunching was rooted more deeply in the minds of economic writers than common sense. Or had they been told to calm down their readers because the print media bosses themselves were about to jack up prices?

Only after public disbelief in official soothing became too pressing, the Wiesbaden statisticians finally came around. They looked again at their computer screens and found — surprise, surprise — that, indeed, some (mostly harmless, of course) inflationary effect could be attributed to the introduction of the euro currency.

In all likelihood, we will never know how much inflation really happened between January 1st, 2002 and now. Anyhow, the public in most of Euroland has learnt a lesson: changing a currency is a painful experience with more than a faint flavor of devaluation.

Hence the credibility gap. How do we know if the now fashionable fear of deflation is based on credible numbers?

There are, however, a few aspects of the current economic situation which are indeed worrying. Economic research institutes and economic media are telling us that most of Euroland's economy is stagnating because consumers are saving too much and neglecting their duty of consuming.

If, for a moment, we look at the situation from the vantage point of the Italian trade and consumer unions that diagnosed runaway consumer price inflation, we will arrive at a totally different understanding of current problems.

In this perspective, most of 2002 was characterized by a lopsided inflation which pushed up consumer prices without simultaneously — as is customary under a regime of chronic inflation so well known in Euroland — raising incomes. Incomes could not rise because the statistics said there is no inflation.

Squeezed between a rapidly rising cost of living and stagnant private incomes, consumers pulled the emergency brake and reduced consumption. In Germany, for instance, consumers are in droves abandoning traditional trade outlets and flocking to the cheapest of discounters, repeating a probably lasting change that already happened in the U.S. during the recession of the early 90s. The Munich public transport company lost 4 percent of its passengers during the first half of 2002, showing that the likely cause is a shortfall in disposable income rather than excessive saving.

In this perspective, deflation (if there is any) is plausibly the result of the earlier lopsided inflation which pinned consumers against the wall. Retailers, gastronomy, media and public utilities which had raised prices without consideration of the existing consumption potential are now feeling the pinch. In the consumer's eye this could be seen as a well deserved punishment although the longer term economic consequences might be dire.

What does this unusual and unpleasant situation mean for the future of the euro currency? Prospects do not appear very good. A number of governments are violating the stability pact. It remains to be seen to which extent their budget deficits will counteract deflation (provided there is) or induce inflation.

Overall, Euroland still shows the symptoms of a European Inflation Community. In countries such as Italy, inflation is so ingrained that the old games of the lira decades are continuing as if the euro was but a lira with a different denominator. “Raffica di aumenti previsto” — a wave of price and rate increases expected — according to newspaper headlines. Some managers apparently don't feel happy if they can't raise prices or rates at least once a year.

Similar games being played can be observed all over Euroland. In some instances, however, price hikes are not motivated by greed but by despair pervading companies and sectors that have seen their markets melt down in recent months.

Public budget deficits combined with a continuing inflationary mentality appear more threatening to the euro than the spectre of deflation. Even the European Central Bank does apparently not trust current low inflation statistics because it refuses to lower the discount rate.

Despite the ECB's current battle against inflation, some observers don't expect the euro to last more than five years. The coming months will show whether the European Central Bank's defence of the euro proves powerful enough to resist mounting inflationary pressures. Any substantial further loss in the purchasing power of the common currency is likely to cause widespread public disenchantment, especially in countries that prize stability, such as Germany, Austria and France. Calls for re-introduction of the old currencies or dollarization are likely to be heard and might be appropriated by populistic parties.

In any case, the sad experiences of 2002 need to be carefully studied with a view to avoiding future disasters of a possibly even greater magnitude.

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—— Benedikt Brenner