Ed Dolan's Econ Blog

Prices are Falling in the Eurozone, but is it “Real” Deflation?

The Eurozone has been on the brink of deflation for months. The latest data show that for the first time, consumer prices for the currency area as a whole (and for 12 of its 19 member countries) were actually lower in December than a year earlier. But is it “real” deflation?

In a pair of posts [1] [2] last fall, when EZ inflation was merely low, but not yet negative, I explained that there are two kinds of deflation.

The nasty kind of deflation, which everyone rightly fears, is driven by falling aggregate nominal demand. As demand collapses, it drags both real output and the price level down with it. There is a serious risk of a self-reinforcing downward spiral in which debtors can’t repay their loans, defaults and falling asset prices undermine the financial system, zero interest rates render monetary policy powerless, and rising unemployment sparks social unrest.

However, there is also a benign kind of deflation, driven by rising productivity. In that scenario, conservative monetary policy restrains the growth of nominal GDP while real output surges ahead. The rate of inflation is negative, but growing output provides borrowers with the cash flow they need to repay their loans, rising productivity allows real wages to rise, and nominal interest rates, although low, do not need to fall all the way to the zero bound. In the US and UK, such productivity-driven deflation was the norm during much of the nineteenth century and reappeared again, more briefly, in the prosperous 1920s.

So which kind of deflation is Europe facing now? The bad, demand-driven kind,  or the good, supply-driven variety? A little of each, it seems.

The good news is that the recent transition from positive to negative inflation for the EZ as a whole comes largely from the supply side via falling energy prices. As the next chart shows, core inflation—the CPI with energy stripped out—remains positive.

For an importing area like the EZ, the impact of falling oil prices is much the same as that of productivity growth. To understand why, imagine that the EZ were a closed economy that produced all of its own oil, and that some technological breakthrough doubled the productivity of the oil industry. Only half as many resources as before would be needed  to sustain oil output; the rest could go to producing other goods and services. The only difference is that currently we are not looking at a decrease in resources needed to produce oil, but instead, a decrease in the resources needed to produce the goods and services that are traded for oil.

The  bad news comes in the form of two big “ifs:” Falling oil prices could theoretically lead to steady growth combined with falling prices, but only if the improvement in terms of trade were sustained, and only if the economy were otherwise healthy to begin with. Unfortunately, we can’t count on either.

Oil imports into the Eurozone amount to about 4 percent of GDP. Roughly speaking, then, the fall of oil prices by half in recent months could be expected to have a beneficial impact equivalent to a 2 percent growth of productivity for the economy as a whole. That is very welcome, but oil prices are not going to fall in half again next year and the year after that. Instead, they are going to stabilize and then rise at least part way back toward the $100 mark. In contrast, the productivity gains that led to growth with falling prices in the nineteenth century and the 1920s continued year after year.

Furthermore, the EZ economy was far from healthy before oil prices began falling. It came into 2014 with inflation under 1 percent and falling, real growth under 1 percent and stagnant, and unemployment stubbornly stuck above 10 percent. Even before oil prices began their plunge in the second half of the year, the Eurozone was already on the brink of a malign deflationary spiral driven by inadequate demand. Several of its members were already over the brink.

So back to our question: Should we call what is happening right now in the Eurozone “real” deflation? Not quite. Right now  both the supply and the demand side of the economy are driving inflation lower, but demand is not yet weak enough to cause outright deflation by itself.

In a best-case scenario, Europe’s fiscal and monetary authorities could take advantage of the oil price windfall to reverse their policies of demand restraint. They could, for example, simultaneously ease budgetary austerity and pursue a program of all-out quantitative easing. By the time oil prices inevitably started to rise again, the underlying economy might be on the road to recovery.

In the worst case, the window of opportunity will close again without anything having been done. If that happens, the threat of a “real” demand-driven deflationary spiral will still be there.

Follow this link to view or download a tutorial on deflation in theory and practice

9 Responses to “Prices are Falling in the Eurozone, but is it “Real” Deflation?”

windblastJanuary 18th, 2015 at 9:48 am

Why are you calling for QE?

Interest rates are at zero and the exchange rate has plummeted. As those are the only benefits to the economy of QE, it will not do anything at all except maybe boost asset prices. Which only puts wealth into the hands of the rich.

Fiscal policies are required to ease the issues, not QE. But governments are still sitting on their bottoms and expecting some sort of Draghi magic to fix all their woes.

But, as we all know now, only an exit from the EUR will help the peripheral lot.

Ed Dolan EdDolanJanuary 18th, 2015 at 10:44 am

If you follow standard macro theory, the exchange rate effect of QE should provide a boost to aggregate demand by discouraging imports and encouraging exports, so it is a bit of an exaggeration to say "it will do nothing at all." However, I do not mean by this to downplay the importance of fiscal policy.

windblastJanuary 18th, 2015 at 12:28 pm

The Eurozone already has a positive current account balance.

Add in that most of the Eurozone international trade remains within the Eurozone, so they are all selling to themselves, meaning that if the EUR falls it will have very little effect. Except maybe a bit of inflation if the oil price rises again.

QE is now mentioned by all the pundits as the universal panacea, and I get the feeling the the Central Bankers are getting a bit fed up with these unrealistic expectations shoved upon them.

And don't get me started on the inflation/deflation crap.

After many years of, "Oh my god, deflation is the absolute pits, so we need more QE", there is now a lot of reverse pedaling, "Ahhh, falling consumer prices, enjoy. It is not so bad.".

Discerning bullshit economics is impossible. It is probably mostly all bullshit.

windrivenJanuary 18th, 2015 at 11:37 am

"rising productivity allows real wages to rise"

But that has not been the case in the US since roughly 1970.

Capital might claim that those productivity gains owed to capital investments in automation. Be that as it may, stagnant real wages are not going to spark a stampede of demand. As the graph above suggests, labor has only managed modest income growth by increasing working hours in the household unit.

windblastJanuary 18th, 2015 at 12:37 pm


On the button.

In the developed countries it is difficult to see where productivity gains can be achieved by the labour force and so give the labour force will higher salaries. Automation means less labour is required, competition from low wage countries ensures that it is not profitable to build up labour intensive plants.

We are experiencing the globalisation of the economies. Which means that wages will rise in the producing countries and sink in the consuming countries. A balance has to be achieved.

It has been been painful and will continue.

But none of the politicians will come out and say we're in the shit. Figures will be fudged and the populations will wonder why they are not any better off than two decades ago.

windrivenJanuary 18th, 2015 at 3:26 pm

Hi. Absolutely consonant with my thoughts.

"A balance has to be achieved. "

And that realization can lead one to some disturbing places. In nominal democracies there will be a tipping point but will the vox populi be ignored in the breach?

Do I infer correctly that you are Canadian?

windblastJanuary 18th, 2015 at 10:44 pm


Nope, from the UK. But escaped from there three decades ago.

The decline in of the developed economies has been grinding remorselessly on for at least decades. Japan is now at over twenty five years of flatlining at best. Because this is such a long drawn out process the people are not experiencing a sudden decline, so I don't know where a catalyst can come from.

There is no improvement, but things are not so bad people will react and because they are all in the same state there is not an obvious chasm between the wealthy and the rest.

As a final note (I could ramble on forever) it is interesting how the "deflation story" has changed in the last few months. For years deflation has been called the "real bad boy" and anytime a bit of disinflation appeared, up came the universal shout, "QE QE and more QE".

Now there are hopeful signs that people are finally understanding that QE does not produce CPI inflation, nor does it give the banks money to lend out (a total misunderstanding of how the banks work has been shown all the way up to Obamah), nor does it create jobs.

QE only directly pumps up asset prices, lowers interest rates and puts liquidity in the form of reserves into the banking system.

But now "deflation" is heralded as a "good thing", so enjoy it and buy more stuff while you can, because it won't last forever.

Maybe not, but we're on the road to Japan, that's for sure.

llisa2u2January 22nd, 2015 at 9:54 pm

Thank you for your article. Sure wish your article was published on Bloomberg to counter the very incomplete information that is getting read alot by a lot of people.

Your and Bossone's articles sure start to fill in the big gaps to explain the limitations of QE. and some of the why's, and explore alternatives.

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