Thoughts on easy money and the “threat” of deflation

Today the Bundesbank expressed concerns over the rise in housing prices, being the result of all the cheap credit in the economy issued by the ECB, rather than coming from genuine demand.

The Bundesbank also rightly voices their concerns over future price inflation, but were told that deflation may pose a threat to certain eurozone areas.

The point the Bundesbank makes is indeed correct.  The previous attempts by the ECB to boost the economy have done nothing but exacerbate the problems that the same policies helped produce, mainly, lowering interest rates. All this has done in recent years is reinflate asset bubbles, such as housing and the stock market in a way that is unsustainable.

We may even say that the Fed and ECB have created localised inflation, by providing unprecedented amounts of liquidity to the financial system, which has lead to price increases in financial assets.

However, over time this will spread to the real economy, leading to price inflation.

But isn’t everyone warning about the threat of price deflation?

They are indeed, though I find two main problems with this argument.

The first, is that the danger of deflation is overstated, giving an unfair bias in favour of moderate inflation. Economists warn of a vicious cycle of under-consumption, since people are expecting lower future prices. This is simply plain wrong. It is well known, for example, that apple products will be more affordable a few months after their release, but that doesn’t stop people from cuing up for hours to get the latest iPhone.

Deflation is not optimal, but as a consumer I would definitely prefer falling consumer prices rather than increasing. Wouldn’t you?

The second issue I have, is that I don’t really believe we can speak of price deflation. Like I’ve said previously, the CPI does not accurately measure inflation. Furthermore, if the 2000-2009 period represented a period of inflation, certain downward trends in prices would represent a return to normality, rather than deflation. What I mean is that, for example, falling house prices should not be seen as deflationary, but rather as a return to normality.

What I argue, is that perhaps a period which should be deflationary, as in the case of the 1930s depression, gets turned into mildly inflationary, bur in reality this hides more inflation than meets the eye.

There is an intrinsic mistake with the judgements we make about deflation. After all, in one sense, isn’t deflation what the ECB wants? Isn’t the idea of structural reforms to make europe more competitive, i.e. offer products at lower prices?

When you think about the issue like this, you realize that “deflation” can be due to different things and indeed we should distinguish between monetary deflation, caused by an increase in the value of the currency, and another type of deflation, such as the one that occurs when you make your markets more competitive.

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