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How Deflation Is Actually Lifting European Economies

Bloomberg, Mar 26, 2015

Euro Banknotes As Currency Declines To Nine-Year Low

How Deflation Is Actually Lifting European Economies

Europeans have been warned for more than a year that an ogre called deflation is stalking their economies. Now the ogre has arrived, and guess what? It’s stimulating growth.

The danger of deflation, economists will tell you, is that when prices start falling, consumers curb their spending in anticipation of even lower prices. (Why buy a car now if it might cost less a month from now?) That can send an economy into a downward spiral, as reduced consumer demand leads to lower production and in turn to job losses that drag down consumer spending even more.

But consumers in the euro zone have been buying more, even as the consumer price index has declined for three consecutive months after remaining nearly flat for much of last year. Consumer spending across the 19-nation zone picked up during the second half of 2014 and has continued this year, with retail sales in January up 1.1 percent from December. “There are clear signs that euro zone consumers are currently taking advantage of deflation or very low inflation to lift their purchasing,” analysts at IHS Global Insight wrote in a March 25 report. Consumer spending, rising at about twice the rate of overall economic growth, “has been the main driving force for the euro zone economy since mid-2014,” they wrote.

Deflation, it turns out, can sometimes be helpful.

The main contributor to Europe’s current deflation is a sharp reduction in oil prices, as well as lower food prices. But prices of most other goods and services have remained fairly steady, reducing the temptation for people to hold off on major purchases.

At the same time,  the weakening of the euro against the dollar is giving a competitive boost to European manufacturers, and some are starting to hire workers, which helps fuel consumer confidence. The European Commission reported this week that consumer confidence across the euro zone is at its highest level since 2008, with surveys showing more people expecting to make major purchases in the next few months. Even in Greece, confidence is at a five-year high.

There’s also pent-up demand. In such countries as Spain that are pulling out of prolonged economic downturns, “households are no longer able to delay purchases,” says IHS economist Howard Archer. “They’re embracing the fall in prices and spending now.” Even the famously thrifty Germans have opened their pocketbooks, as lower interest rates reduce the incentive to save. German consumer spending has accelerated more than 3 percent since mid-2014, compared with annual growth of less than 1 percent during the previous two years.

It probably won’t last. Oil prices have stabilized in recent weeks, which means the overall consumer-price index isn’t likely to keep dropping. That’s good, because an extended bout of deflation brings the risk that employers will hold off on pay raises, figuring that workers are already enjoying greater purchasing power. But people who don’t get raises may be reluctant to splash out on big purchases, which could put the brakes on economic growth. In Britain, where the inflation rate fell to zero last month, Bank of England chief Mark Carney has been warning employers not to use lower prices as an excuse to skimp on wages.

It may be too soon to declare, as Gabriel Stein of Oxford Economics Asset Management Services did on Bloomberg Television recently, that “Deflation is now no longer an issue” in Europe. But it’s clearly not the monster it was once thought to be.