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Deflation Worries
Lino Sau
Department of Economics and Statistics
“S. Cognetti de Martiis”
University of Turin
(Italy)
Prepared for a seminar on Current Crisis, University of
Torino, March 11th, 2015 and for PKSG (Post Keynesian
Study Group), Robinson College, Cambridge (UK)
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• There has recently been a marked increase in
concern about deflation, particularly in the
euro zone.
• As even both the Financial Times and The
Economist recently (2013) put it: the ghost of
deflation is in the euro zone!
• Relatively few people alive today have
experienced deflation, but for Europeans that
may now be changing. Indeed, prices are
falling and inflation remains stubbornly low.
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• Eurostat index shows that inflation dropped to 0.9%
for the euro zone as a whole since September 2013.
That is way under the European Central Bank
(ECB) target which is close to 2%.
• Over the past months the trend has intensified.
France, Italy, Spain, Portugal, Greece, Cyprus,
Ireland, Slovakia, Slovenia, Estonia and Latvia
have all seen price falls, and already have one foot
in deflation.
• Much the same is happening in Bulgaria, Romania,
Hungary and the Czech Republic. Poland is at
zero. Denmark is close, and so is Sweden.
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• As we know all too well, the phenomenon of
persistent falling prices across the economy
blighted the lives of millions of people in the
1930s.
• In this connection Irving Fisher tried to explain
this macroeconomic malady in his well known
“Debt Deflation theory of Great Depressions”
(Econometrica, 1933), which may be considered
the seminal work for the development of the socalled debt deflation school (Keynes, 1930;
Tobin, 1980, Minsky, 1982 et al.) in political
economy.
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Fisher’s assumed that: “at some point of time, a state
of over-indebtedness exists, this will tend to lead to
liquidation. Then we may deduce the following chain
of consequences in nine links:
• (1) Debt liquidation leads to distress selling and to
• (2) Contraction of deposit currency, as bank loans are
paid off, and to a slowing down of velocity of
circulation. This contraction of deposits and of their
velocity, precipitated by distress selling, causes
• (3) A fall in the level of prices, in other words, a
swelling of the dollar. Assuming, as above stated, that
this fall of prices is not interfered with by reflation or
otherwise, there must be.
• (4) A still greater fall in the net worth of business,
precipitating bankruptcies and
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• (5) A fall in profits, which in a "capitalistic," that is, a
private-profit society, leads to a fall in aggregate
investments
• (6) A reduction in output, in trade and in employment
of labour. These losses, bankruptcies, and
unemployment, lead to:
• (7) Pessimism and loss of confidence, which in turn
lead to
• (8) Hoarding and slowing down still more the velocity
of circulation. The above eight changes cause
• (9) Complicated disturbances in the rates of interest, in
particular, a fall in the nominal rates and a rise in the
real rates of interest.
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Over the years the theory of debt deflation
considered above has come in for criticism on
various fronts.
• 1st. Deflation process is indeed rare, and even of
little theoretical or practical relevance.
• But! it is worth noting that the persistence effects
considered above can also come about without a
simultaneous fall in the level of consumption good
prices and capital goods; all that is needed, in fact, is
for the deflation process to hit the prices of real
and/or financial assets – a case by no means rare or
isolated in the economic history (cf. real-estate busts
in recent time (Arestis-Karakitsos, 2003; Sau, 2013).
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• 2nd. Mainstream economists observed that a fall in the
general level of prices can have reasonably limited
effects since it brings about a simple redistribution in
wealth from debtors to creditors:
But! At this regards Tobin (1980) demonstrated if the
marginal propensity to spend on the part of the
debtors (consisting mainly of entrepreneurs and
households) is, as might reasonably be expected,
greater than that of the creditors, the fall in prices
may prove far from stabilising.
Furthermore if the debtors go bankrupt the creditors
find themselves having to bear the heavy losses in
part through credit recovery and also due to the state
of widespread insolvency.
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Then on proceeding from static to dynamic analysis,
it immediately becomes crucial to consider the role
of expectations vis-à-vis future prices.
• It is quite possible that the original price decline will
lead to the expectation of further declines.
• Purchasing decisions will be postponed, aggregate
demand will fall off, and the amount of
unemployment increased still more.
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• New approaches inside the debt-deflation school
have taken into account the increasing complexity
and integration in the financial systems during the
age of globalization due to the adoption of the neoliberal paradigm by many emerging and developed
countries.
- In the US, this paradigm stemmed on late 70’s and
was followed and embraced by many European
countries during the 80’s and 90’s: laissez-faire
principle in financial globalization and the process
of securitization.
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These processes has driven the US financial system
towards an overall financial fragility: on the part of
lending institutions, households and purchasers of
mortgage-backed securities up to the crisis.
(i.e lenders provided funds to borrowers, through
subprime mortgage contracts, only due to a belief that
the housing value would continue to increase, but this,
in turn, promote the increase i.e. self-fulfilling
prophecy)
→ By contrast with Fisher’s approach, exogenous vs.
endogenous over indebtedness and assets (realestates) boom and busts as main ingredients of the
subsequent risk of debt deflation process in the USA.
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- the over-lending process by institutional MM
(money managers) investors, banks and other
financial institutions
- the over-borrowing by households and firms even if the latter play a passive role in the
process (because of financial constraints link
to the increase in income inequalities) - since
the process was driven by an excessive
supply of available funds, through the over
mentioned deregulation and financial
innovations.
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• As soon as the payment obligations increased at
a higher rate than the expected future cash-flow;
the financial institutions in US will be driven to
hold that the new financial structure had
deteriorated too much
↓
they deemed the increase in leverage excessive
and then pushed for a reversal in tendency
↓
• The worsening of the “state of credit” lead to a
drop in employment and in the production
financed with loans and a fall in the value of the
collaterals (i.e. houses, equipments and financial
assets).
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→ when the bubble progressively burst, the
progression analyzed previously for the boom
and the “over lending” phase must now be
reversed
↓
progressively lending standards was raised by
financial institutions causing households and
businesses de-leveraging of their positions.
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• At this point as the credit available to the
private sectors was rationed or the conditions
on which they could get access to credit
became more onerous (i.e. credit crunch)
↓
• households and distressed firms were forced
to liquidate their financial assets, or even
sold (no orderly financial markets as assumed
in the EMH) their real estate in order to meet
their obligations.
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• Furthermore through the effect on the
general price levels, there were further drops
in the internal net worths (i.e. difference
between assets and liabilities) of households
and firms in real terms.
• Such a situation had the seeds by a Fisher’s
debt-deflation spiral.
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• BUT! in the USA the fall in the general level of
prices, in the aftermath of the crisis, was
partly avoided, thanks to:
• Huge quantitative easing (QE) policies by the
FED
• and expansive fiscal policies
SPENDING) by the Government.
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(DEFICIT
• The Europeans were not completely
responsible for the crisis, yet they have
become its chief victims.
• The origin of the current European crisis
indeed can be directly traced back to the US
crisis of 2007–2009 over depicted which
spilled over into a sovereign debt crisis in
several euro area countries in early 2010.
• The prominent role of the inter-bank market
caused a chain reaction and a contagion within
the area.
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• In many of these countries, government
bailouts of banking and financial systems
contributed to an increase in public debt.
• Private debt became public debt, be it
through banking crises or the burst of
housing bubbles, leading to the sovereign
crisis.
• The latter begin with Greece, but
suddenly spread over some other
countries of the euro zone like Portugal,
Ireland, Italy and Spain.
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• Between 2007 and 2010, the debt to GDP ratio
of the euro area increased from 66.3% to
85.4%;
• The most dramatic increase in public debt occurred in
Ireland where the country’s debt problems can be
clearly ascribed to the country’s banking crisis. On 2006
the central government financial balances as a percent
of GDP was positive and close to 2.9% (see OECD
Economic Outlook 89 database tab. 27). The situation
changed in the course of the Irish banking crisis (2008)
when the Irish government, under pressure from
European governments and institutions but also from the
US government, guaranteed most liabilities of Irishowned banks.
• Indeed, in Ireland on 2010 the budget deficit as a
percent of GDP was close to -32.4%.
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• Like Ireland, Spain did not have a fiscal or debt
problem before 2008. Again, on 2006 the
financial balances as a percent of GDP was
positive and close to 2.0%.
• Spain’s situations changed when the global financial crisis
put an abrupt end to a long cycle of high growth (which
started around 1996) that had been accompanied, like in the
US, by a construction and real estate boom. When output
contracted in 2008, the Spanish housing bubble burst and
destabilized the banking system.
• On 2009 and 2010 the budget deficit in Spain
raise up to -11% (see OECD Economic outlook 89
database, tab. 27).
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• According to the statistics by OECD economic
outlook quoted above, countries like Ireland,
Spain, Portugal and Italy (where the debt level
was above 100% of GDP prior to the crisis, but
unlike the Greece the debt to GDP ratio fell
between the adoption of the euro in 1999 and
2007) showed a high degree of fiscal
responsibility in the six years prior to the crisis.
• That is, rather than the result of government
profligacy, the sovereign crisis in these countries
is the result of the latest phase of a crisis caused
by a flawed financial and economic model.
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• If it is not enough, Europe's policy regime is
inflicting ultra-austerity and is aggravating
the situation further.
• By mistakenly blaming the EU crisis on
profligate states and by imposing a crash diet
of fiscal cuts on many countries, they have
made the problem of private debt and public
even worse.
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• The policy is self-defeating in broader
economic terms. Indeed when income is
declining, fiscal positions worsened (tax
revenues decrease and transfer payments
grew larger due to rising unemployment
during the crisis).
• But the central contradiction of Europe's debt
crisis strategy is link to some sort of debt
deflation bias.
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That is many countries are forced to cut
wages and prices for competitiveness reasons
→ this frustrates the other objective of
controlling the debt since deflation increase
the debt burden, worsening the situation.
→That is: they are damned if they do, and
damned if they don't. Something like a
Scilla/Cariddi dilemma.
• As Fisher (1933, p. 344) argued: “…then we
have the great paradox which, I submit, is the
chief secret of most if not all, great
depressions: The more the debtors pay, the
more they owe”.
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• The risks that deflation engenders are well known.
• First, by creating expectations that prices will be lower
next year it gives consumers incentives to postpone
purchases. As a result, aggregate demand declines
putting further downward pressure on prices.
• Second, since private and public debts are fixed
nominally, declining prices increase the real burden of
the debt and the real interest rate.
(Put differently, as prices decline government and private revenues
decline while the service of the debt remains unchanged. This
forces the private and public sectors to spend an increasing
proportion of revenues to service the debt, forcing them to cut
back their spending on goods and services. This in turn increases
the intensity of the deflationary process)
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• The second effect, the debt-deflation dynamics,
is already working. It is important to stress that
this effect does not crucially depend on inflation
being negative. It starts operating when inflation
is lower than the rate of inflation that was
expected when debt contracts were made.
(Thus, during the last ten years inflation expectations in the euro zone have
been very close to 2%. Current nominal interest rates on long-term bonds
reflect the expectation that inflation will be 2% for the next five to ten years.
However, inflation in the euro zone has been declining since early last year
and now stands at 0.8%. This debt-deflation dynamics, which are of the same
nature as those analyzed by Irving Fisher. The nominal debt increases with
the nominal rate of interest (which includes a 2% inflation expectation), but
the nominal income in the euro zone increases by only 0.8%. As a result, an
increasing proportion of these revenues must be spent on the service of the
debt).
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• Mario Draghi recently has declared that the ECB “will do
whatever it takes to avoid a crisis of the euro” and on
January 22nd he has promoted a QE plan for Europeans
countries to avoid deflation.
• Draghi’s plan will inject nearly $60 billion a month into the
euro economy to prevent deflation, push down the euro
and restore confidence in the shared currency.
• At first glance, it appears that Draghi fired the proverbial
big bazooka that will blast Europe out of its lethargy. The
ECB’s quantitative easing — the flooding of financial
institutions with money to promote increased lending and
liquidity — is not without merit. The $1.5 trillion monetary
stimulus program, which will be disbursed over the next
two years, is bigger than anyone had imagined.
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• Unfortunately this is a necessary but not sufficient
condition to sort out the euro-zone from deflation….
and to avoid a Great Depression.
• Part of the plan is to push down the value of the euro,
thus making European exports more attractive abroad.
• The initial reaction was a surge in stock markets across
the continent and the further decline of the euro, to
1.12 per U.S. dollar.
• But investment is the foremost goal, and interest rates
are already at an all-time low. The problem is that
businesses are not investing because there is a
pervasive fear that they won’t be able to pay back
their loans, regardless of the interest rate.
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