The world’s economists are worried. Prices, you see, might be dropping. As in everyday items getting cheaper. It’s known as deflation and, despite any excitement you might have at spending less on a car or house or petrol or clothing, it is a problem, dpa reported.
It also comes with a secondary problem: how do economists make people understand that falling prices might be a problem?
“The problem is when people make bets that prices will decline,” says Roland Doehrn, an economist with the Essen, Germany-based think tank RWI.
“They make an assumption, when I buy a product in a day, it will be less expensive. They will hold back their spending.”
But that doesn’t quite get to the heart of the matter. After all, if your basic incomes and expenses remain unaltered, what do you care if prices are dropping all around you?
The answer is that it’s hard to sit safely on the sidelines should deflation settle in. If prices start dropping, businesses have to respond somehow, because they will be earning less. That means cutting jobs, slashing salaries or, in a worst case scenario, going out of business.
If that happens in enough parts of the economy, pretty much everyone will feel the pain. Even if a worker manages to stay employed, the odds are that he or she will be earning less.
But again, if a worker is earning less, but prices have all gone down, is that really so bad?
The answer would be no, assuming no debt. However, as soon as debt enters the picture, it becomes ugly. Salaries may slide downwards, but the level of debt owed remains unchanged.
Little Inflation Necessary
That means, in a deflationary situation, just about anyone who has borrowed money needs to pay off the same amount, just with less income.
That’s why economists see a certain level of inflation as necessary. Not only does it indicate the economy is improving, it also improves the average person’s standard of living in relative terms: their salary goes up, but their level of debt will generally grow at a slower pace.
“When there is inflation, your debt becomes lower year by year, because your earnings are increasing along with inflation.”
That turns around with deflation, he notes. “When prices are going down, then the ... amount of hours you have to work to enable you to pay back your debt will increase in the end.”
And deflation is not something policy makers can wish away. Developed economies are terrified of the Japanese scenario, where deflation took root more than two decades ago and has remained persistently present despite some recent pushes by the government.
“Of course they are an advanced society,” notes Gregory Claeys, an economist with Brussels-based think tank Bruegel. “But it’s still a Japan very much below the level we were expecting at the beginning of the 90s. They could have done much better.”
Entering Deflation
Further complicating the matter is the debate about defining when a region enters deflation.
In a paper published earlier this year, Claeys wrote: “Even though the euro area as a whole has not yet entered into deflation, this picture is worrying.”
He says he has argued for the European Central Bank (ECB) to be more proactive, buying up assets, which should, in theory, drive up demand, boost the economy and cause an uptick in inflation.
“They have been a bit too slow to act. They are taking the measures we suggested back in April, but they are only starting to implement them now.”
Nonetheless, it’s clear the problem still weighs heavily on European lawmakers. The topic has become a regular issue during ECB President Mario Draghi’s monthly press conferences, prompting regular promises that he is ready to take any and all action to fend off the threat of lower prices.
