Deflation Threat in Europe, Failed Policies and a Possible Solution

by the Curmudgeon with Victor Sperandeo


Consumer prices in the Euro-zone (the European countries that use the Euro as a single currency) rose at only 0.3% last month, the European Union's statistics office reported on Friday.  That's down from 0.4% in July and 0.5% in June, marking the lowest monthly inflation rate since October 2009. It's causing economists to worry if this is the start of a decade of Japan style deflation in countries that use the Euro. 


[By contrast, core inflation, which excludes more volatile prices for food and energy, climbed unexpectedly in August to 0.9% from 0.8% the previous month.  We don't believe core inflation is meaningful, because it excludes the two items everyone must buy -- directly or indirectly.]


Five of the euro zone's 18 countries have experienced falling prices, according to BNP Paribas. Consumer prices in Italy were 0.2% lower in August than 12 months ago – the country’s first bout of deflation since 1959. Greece, Spain, Portugal and Slovenia are also experiencing falling prices.  The threat of deflation is very real in Spain, which has a public and private debt load equal to about three times the size of its gross domestic product.


The slump in inflation is continuing to trouble the European Central Bank (ECB), which predicted only two months ago that inflation would average 0.6% between July and September.  Expectations have risen that the ECB will announce it is taking steps to address the deflation threat at his monthly meeting next Thursday.


ECB Executive Board member Benoit Coeure said the ECB was ready to adjust its monetary policy further if needed and boost bank liquidity in Greek newspaper Ta Nea on Saturday, Reuters reported. 

Before that, ECB President Mario Draghi said at the global central bankers happening in Jackson Hole, WY that the central bank would use “all the available instruments” to address low inflation.  [2 years before that, Draghi said the ECB would do whatever it takes to save the Euro.  What else is new?]


Draghi has repeatedly warned that the financial markets inflation expectations are tumbling.  He recently said: "Over the month of August financial markets have indicated that inflation expectations exhibited significant declines at all horizons."  In particular, the most closely watched measure of Euro-zone inflation expectations – the average rate expected over five years starting in five years’ time – fell to 1.95% last week. 


Some ECB-watchers point to what could be simply temporary factors limiting price increases in the Eurozone. A fall in energy prices amid oversupply of oil and other commodities has been one of the main factors pushing inflation lower.  Russia’s ban on food imports from the EU is also keeping a lid on food prices as demand is lower than it otherwise would be. But others disagree.


“The issue this time is that inflation is lower on a persistent basis which is more important for expectations than when people assume it is volatile,” said Luigi Speranza, an economist at BNP Paribas, pointing out that low expectations of inflation can affect people's behavior, for example by depressing wage demands, leading to a vicious circle.


Mr. Speranza argues that in an environment of already depressed inflation expectations, it can take just one disaster -- such as the Asian financial crisis of the late 1990s for Japan -- to push a country or entire monetary zone over the edge.  “Europe is not there but it's one shock away from it. If you wait for the shock to arise it might be already too late,” he added.


"The Euro zone is one big shock away from deflation," said Stephen Cecchetti, Professor at Brandeis University.


"Deflation is a serious threat for our business," said Giovanni Ferrero, Chief Executive of Ferrero International SA, the Italy-based maker of Nutella, Tic Tac and other candies and chocolates.  "We're not only in a situation of low inflation. In some markets, distributors are asking us for deflation," he said, referring to price cuts. Although this can be a positive for consumer pocketbooks, the trend "in reality destroys value," he said. "The cost of production is constantly on the rise. It's unthinkable to expect that prices couldn't recover costs without cutting cash-flow generation, investments and jobs."


Weak or falling prices make it harder for households, businesses and governments to service debts that are typically paid off at fixed interest rates, since incomes and revenues stagnate in a deflationary environment.  Over the longer term, very low or declining prices tend to damp business investments and hiring. Companies can't cut costs fast enough while wages are hard to lower. Profit margins decline and losses may follow.  Banks can't make loans as easy in non-inflationary periods and debts don't get inflated away. Consumers put off purchases in anticipation of lower prices for the same merchandise.  Final demand collapses.  A recession generally follows.  All of the above was characteristic of Japan's "lost decade" of very low economic growth accompanied by falling prices.


Several economists believe that the Euro-zone's ~0% economic growth in the second quarter of 2014 was due to the threat of deflation which dampened demand for goods and services.


"The environment in terms of pricing is very challenging," said Alexandre Ricard, Deputy Chief Executive of Pernod Ricard SA, which sells drinks ranging from Absolut vodka to Martell cognac.


Pernod Ricard reported on Thursday that despite the pressure on prices amid low inflation in Europe, the company was able to increase prices for its drinks on average by 2% in its fiscal year which ended June 30th. Mr. Ricard predicted that in the 2014-2015 year, the company won't able to push through price hikes that high.


Central banks strive for low or moderate inflation, rather than deflation or falling prices. When inflation is too low, central banks have recently used extraordinary measures, such as negative interest rates or asset purchases (AKA Quantitative Easing), in an effort to stimulate their economy.  Victor doesn't agree with those policies as indicated in his comments below.


The ECB has said Quantitative Easing (QE) is an option, but has resisted it on the expectation that inflation will gradually rise. QE policy is very unpopular in Germany, where it stirs deep-rooted fears of politically captive central banks financing governments by printing money, which invariably leads to hyperinflation (which was experienced in the 1920s during the Weimar Republic). 


With the ECB having waited so long to employ QE, analysts at BNP Paribas ask "whether it is already too late." The investment bank believes that a QE policy is unlikely in the near future, because several members of the ECB's Executive Board still have a lot of skepticism about the effects of asset purchases on European economies.


Victor's Comments:


Let's first ask why aren't declining prices (deflation) good for a nation and its consumers? Well, it's not always a bad thing.  For example, many high tech products seem to be always declining in price, which benefits consumers.  The big, brand name tech vendors like Apple, Samsung and Google are doing well (mostly because they can maintain their profit margins when component costs drop due to their huge scale and large sales volumes). 


I respectfully disagree with the premise that only a tiny increase in prices (e.g. 0.3% last month in the Euro-zone) requires unconventional ECB measures like negative interest rates or QE.  Lower prices tend to help the consumer and the majority of people in the nation-state (or in this case, Euro currency block of countries).


Price stability is what's needed in the long run.  Let's now examine how that might be achieved by changing the failed policies of the Euro-zone politicians, based on the principles of two great, historical economists.


In my opinion, one of the top five greatest books of all time is the "The Wealth of Nations," written by Adam Smith and published in 1776.  It discusses in detail what creates growth (which in turn creates wealth).  Here's an important quote from the book:


"That State is opulent where the necessaries and conveniences of life are easily come at...To talk of the wealth of nations is to talk of the abundance of the people. Therefore, whatever policy tends to raise the market price diminishes public opulence and the wealth of the state, and hence it diminishes the necessaries and happiness of the people."


Note:  The above quote, along with those from several other great economists, is included in one of my previous Curmudgeon posts on the global trend towards Socialism. 


[My comments and quotes concern the people’s point of view and the wealth of a nation, rather than particular groups or industries within a country or currency block.]


Adam Smith goes on to explain why anything that raises the market price (i.e. inflation) hurts a nation and its people.  So why do Central Banks want inflation?  The bankers want it to allow debts to be repaid (in cheaper real money) and to not prevent them from creating money "out of thin air" and then collecting interest in the process (which is exactly what Fed member banks are doing today with the excess reserves created by QE).


Smith wrote: "Where the necessaries and conveniences of life are easily come at... [i.e. low costs of shelter, food, clothing, energy, water, transportation, and other necessities], they should not be artificially raised if a nation is to be wealthy."


I believe the policies of the European Union (and most other nations) are the exact opposite of what Adam Smith concludes and has been confirmed through historical observations. The EU wants to raise prices, which Smith says "diminishes public opulence."


The "Brussels (EU) Socialists," one and all, oppose rising prices which in effect creates poverty for the people (not wealth), according to Smith.  Their fiscal policies -- focused on achieving a 3% ratio of annual budget deficits to GDP -- have been anti-growth and have trended towards the French/Euro model of "Socialism."  Austerity is also associated with this political philosophy, e.g. raising taxes, somewhat lower spending, and increasing regulations on business. 


Smith wrote:  "Consumption is the sole end and purpose of all production; and the interest of the producer ought to be attended to, only so far as it may be necessary for promoting that of the consumer."  Does that sound anything like what the ECB (or Fed, BoJ, other central banks) is saying now?


We must also seriously examine the producer side of the economy. This is best addressed by Jean-Baptiste Say (1767-1832), who is generally credited with the creation of what is referred to as "Say's Law", which is the original version of what has developed into modern "supply-side" economics.


The basic tenet of supply-side economics is that the level and extent of aggregate demand is a function of the long-term trend of innovations and new inventions. That trend is a direct function of the demand for workers and their productivity. The number of workers demanded, along with their productivity, depends on the rate of capital investment by the private sector.  Such investment is caused by market demand and the quantity/ quality of innovations and inventions.


New products are driven -- like almost all human endeavors -- by INCENTIVES, and by a group of risk takers called entrepreneurs. These entrepreneurs are generally supplied with capital by a similar group of risk takers called Venture Capitalists or Angel investors, who measure each entrepreneurial opportunity as a ratio of "risk to reward." These two groups thrive in direct proportion to the level of economic freedom, (low) tax rates, and (lack of) regulatory interference found in a nation.                     


Say's Law operated with great results during the internet and dot-com boom in the mid-1990s (until excess speculation and over-investment resulted in the dot com bust in 2000-2001).  Supply-side created demand as eBay, Yahoo, Amazon, Google, and many more great businesses flourished. Huge wealth expansion resulted for all, while the growth in profits and increased tax revenue created by these innovators helped balance the Federal budget. In the same period, Main Street saw 4% real GDP growth while employment and wages increased across the board. 


Without the confidence that governments will stop increasing regulations and raising taxes (which are huge obstacles to growth for both consumers and businesses) nothing will change.


A key message from the above discourse -to both the ECB and Euro-zone policy makers in Brussels -- think about consumption and pro-business fiscal policies driven by supply side economics as advocated by Smith and Say, respectively.  We suggest Draghi and politicians in Brussels read and follow the policies espoused by Messieurs Smith and Say!


Till next time......


The Curmudgeon


Follow the Curmudgeon on Twitter @ajwdct247

Curmudgeon is a retired investment professional.  He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996.  He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies.  Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.

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