What if the Euro Area Falls into Serious Deflation?

Yves here. This post explains indirectly why one of the “reforms” that the creditors have been insisting that Greece implement is “liberalizing” the labor market, which is bureaucrat-speak for squeezing workers. Astute readers will notice that the logic is based on the loanable fund model, which we’ve been debunking every time a good paper or story gives us an excuse to return to that theme (see this post for a recent discussion).

By Philip Arestis, Professor of Economics at the University of the Basque Country, Spain and Malcolm Sawyer, Professor of Economics, University of Leeds. Originally published at Triple Crisis

The economies of the euro area monetary union are close to deflation. In May 2015, the annual rate of inflation averaged 0.3% across the euro area, after six months during which the rate of inflation had been zero or below. The question then arises as to whether the deflation has been internally or externally generated, whether it becomes self-perpetuating, and what the consequences would be.

The dramatic drop in global oil prices have had a significant effect in the reduction of the rate of inflation, though with some recent rises, this dampening effect on inflation may have come to an end. The threat of zero or negative inflation means that households and firms, which are heavily indebted, find it difficult to service their debt, partly because its real value increases with falling prices and also because current household income is falling and firms are reluctant to invest in view of expected falling demand.

Deflation could well compound the lack of aggregate demand which stalks the euro area. The strategy of the euro area to reduce unemployment is based on a twin track approach of reducing budget deficits based on a belief in “expansionary fiscal consolidation,” and reinforcement of so-called structural reforms to make labour and product markets more “flexible.” But structural reforms and improving competitiveness entail flexible labour markets, a lower minimum wage, less labour job protection, and a strategy of wage cuts as a way forward.

Surely, though, a successful implementation of these policies would result in lower aggregate demand and lower wages. Consumption, the largest component of aggregate demand, would tend to decrease, being closely linked with wage income. Much reliance is placed by policy-makers on a boost to investment coming from the reduction of budget deficits and lower wages. But the outcome is more likely to be lower investment as aggregate demand is adversely affected. Exports could be aided through lower prices, but much would depend on the response of the euro exchange rate such that the export prices in, say, dollars would change little. In any case, exports by the euro area as a whole are a relatively small proportion of GDP.

One of the arguments for “structural reforms” to create “flexible labour markets” is that “inflexible labour markets” mean that a stimulus to demand (e.g., coming from a reduction in interest rates) is swallowed up by wage and price rises with little effect on output and employment. This is explained by the existence of labour market rigidities, which, in the words of the ECB (2004), “limit the pace at which an economy can grow without fuelling inflationary pressures” (p. 21). Thus, if the ECB lowered the rate of interest in an attempt to expand economic activity in the euro area economy, this would merely be translated into higher prices with only limited effects on real economic activity.

This is the ECB-handicap hypothesis (Angeloni et al. 2003). In terms of labour market reforms, this hypothesis suggests that labour markets should become more flexible if more jobs are to be created, which would promote growth. Available evidence, however, suggests that these reforms are not important in creating jobs and promoting growth. Inflexible labour markets do not appear to be as important as insufficient aggregate demand in explaining the euro area’s inability to increase income and employment. If at all important, they are so in the long run.

De Grauwe and Costa Sorti (2005) investigated the ECB-handicap hypothesis. The authors of this study utilise a “meta-analysis,” which aims first to “statistically analyse the estimated effects of monetary policy shocks on output and prices, and second to identify the factors that can explain the differences in these estimated effects” (p. 4). They employ 83 studies, which report on the impact of interest rates on inflation and output. Four different parameters that measure the effect of monetary policy are examined: short-term effects on prices and output; and long-term effects on prices and output (effect after one year measures the short term; effect after five years measures the long term). Since many of the 83 studies employed report results for more than just one country, 278 parameters that measure the short-term and long-term effects on output are obtained, while only 185 parameters are possible to obtain for the short-term and long-term effects on the price level. An econometric equation explaining these different parameters is employed. The purpose is to control for a number of variables that can affect the size of the estimated coefficients (different estimation methods, different time periods, etc.).

It is concluded that, for the euro area, like for the United States, that the short-term effect on the price level is very small, while the long-term effect on prices is significant. Short-term and long-term effects on output are significant. The ECB-handicap hypothesis is, thus, not upheld. It is, thus, not the case that the ECB cannot affect output because of the existence of rigidities, especially in the labour markets.

We may therefore conclude that the key to avoiding deflation in the euro area, and elsewhere, is not to introduce structural reforms. It is, rather, a solid growth of domestic demand. A stable and healthy wage growth that would encourage consumption and thereby aggregate demand is the solution, rather than structural reforms.

See original post for references

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  1. Christer Kamb

    What is the “Loanable Funds-model” really about? I mean how is it used in the macro/micro-economist world of judging how the economy works?

    As far as I know they are not using debt as a variable, but possibly the asset side. And as we all know to much debt is deflationary. And certainly when money/debt is misallocated.

    1. digi_owl

      Loanable funds boils down to banks issuing loans based on existing deposits.

      So if a bank has 1000 in deposits it can lend out 900 based on a reserve requirement of 10%.

      On top of that you get the money multiplier concept where thanks to the reserve requirement, a initial deposit of 1000 can rotate through multiple loan-to-deposit cycles and thus result in more than 1000 in effective demand.

      But all this hinges on banks lending only from deposits, something no modern bank does.

      As a model it would at best only be valid if a bank had to exclusively deal with physical currency.

      1. Christer Kamb


        Many thanks but the interesting part would be to know how the economists integrate the Loanable Funds-model into their econometrics-models. Maybe it´s not involved at all? They just presume one persons debt is another persons asset? And that´s it!

        1. digi_owl

          As best i call, that it pretty much it.

          The loanable funds stuff allows them to claim that lending do not affect the economy at the aggregate level as it just moves purchasing power around.

          Person A do not have anything to spend on so they instead lend their excess to person B, via the banking intermediary by making a deposit, who goes and spend it instead.

    2. Benedict@Large

      The odd thing about the loanable funds model (which claims that government borrowing slows economic activity) is that the effect they prescribe to excessive government borrowing actually occurs with excessive taxation (i.e., running a surplus).

      1. Christer Kamb


        Hmmm….you mean crowding out the private sector with lower yield on investment relative private investment? Increasing government borrowing must lead to higher private sector surplus(or lower deficits) in a closed economy per se, not government surplus. Taxation is not borrowing.

        But I understand your point that government increase taxation to lower their own deficits. Yes that is logical but not in the US from the Reaganism until today when things seems to fall apart. Taxation in the US will probably skyrocket if inflation stay low or they start a MMT-machine.

        We must keep in mind that investment in i.e public infrastucture is long term. Problem is when you run big twin deficits at the same time as you don´t care to neither invest (or maintain) public resources(intact).

  2. steviefinn

    The ECB’s position as with the Tories in the UK doesn’t have to make any sense as it is born out of ideaology. One thing which is very apparent here in Northern Ireland & I imagine elsewhere, that should be added, is the effect of confidence added to the fact of being tapped out in terms of debt.
    20,000 public sector jobs to go here in the North which in terms of population would be the equivalent of 600, 000 in the rest of the union. Anybody with 2 brain cells to rub together knows there will be nothing to replace these jobs & the long established small business owners I have spoken to know that many of their best customers, due to their one time decent pay & job security, will be lost to them.
    The fact that the Republic is – despite the BS spewed out by their economic ministry of lies, now a dead basket case, which provided work for Northeners mainly in the building trade is another affect that has dragged down the North.

    It will end in tears, is all I know for certain.

  3. Uwe Ohse

    the key to avoiding deflation in the euro area […] It is, rather, a solid growth of domestic demand.

    This will not happen in the euro zone for the next few years. Each and every important policy decision is rather opposed to the growth of domestic demand. They will not be reverted, unless germany and experiences some painful shock (not even if Merkel steps down, because there is no alternative to her in germany, since no possible successor will follow a radically different path).

    But even if that painful shock happens, and german policy makers somehow find their brains (which is not really likely), the germans (the public, not the policy makers) might do what they did so often before, and what they are still told to do: save.

    I’m not sure that the combined brains of the german policy makers account for more working brain cells than one or two dead rats do, but even if they did, it might be impossible for them to change course fast, since it’s never easy to revert decisions, and it’s almost impossible for politicians to revert their own mistakes.
    We’d need to remove the majority of the current crop of german top politicians, and that’s not going to happen in the next few elections (i think we’d need one or more new political parties for that, and pirates and AFD may have killed any chance to found new parties at least for the next few years).

    This crisis certainly will not end soon.

  4. EoinW

    I’ve seen fifty years of inflation and also seen the living standards of people decline through that same period. Perhaps it is time for a little deflation?

    1. steviefinn

      Try telling that to SME’s that employ people whose tight margins are being squeezed from all directions – all part of a vicious circle going ever downwards.

      1. susan the other

        Deflation on top of 50 years of inflation (neither concept can even be defined, mind you…) is like a one-two punch. If the disease doesn’t kill you, the cure is guaranteed. We are just plain dumber than ants. When an ant bed has reached it’s maximum, they at least have the good sense to abandon it. In terms of the Euro requiring austerity to straighten itself out… Wolfgang is trying to equate the Euro with the gold standard. When he knows full well that there isn’t enuf gold to go around. I know!, lets insure the capacity of money to store value by equating it with the rarest element in the universe, whatever that is. How ridiculous. Because you’ve really got to scrimp and save for millenia to accumulate enough of the rarest-most precious thing to cash it in and then loan it out. Jesus.

  5. Demeter

    I don’t understand why Deflation is an Iffy Proposition.

    It’s real, present and growing. It just isn’t talked about.

    When paper assets are reduced to zero value, then we will see some action. Until then….continued inflation of all real goods, continued QE to uphold the price of worthless paper.

  6. craazyboy

    “We may therefore conclude that the key to avoiding deflation in the euro area, and elsewhere, is not to introduce structural reforms. It is, rather, a solid growth of domestic demand. A stable and healthy wage growth that would encourage consumption and thereby aggregate demand is the solution, rather than structural reforms.”

    In other words, if PIGS could fly, we wouldn’t have this problem. QED.

    1. susan the other

      Demand, but for what? The visionary production of things we actually do need to set us right with the planet? Or a bunch of mind-numbing plastic toys? As long as there is a need, there is a demand. We just need some good needs. No?

      1. craazyboy

        Real GDP Growth = Real Personal Income Growth + Real Government Revenue Growth = Aggregate Demand + Debt Service = Buy Anything, On Credit or Cash

        What else is there to know?

        Besides, toys are fun.

      2. cnchal

        . . . Or a bunch of mind-numbing plastic toys? . . .

        The most mind-numbing plastics of all, have electronics inside, and 99.99999999999% of them are made in China.

        . . . The visionary production of things we actually do need . . .

        Incredibly, modern agriculture “produces” enough calories to feed a world population roughly double of what it is now.

        How is such staggering waste possible?

  7. impermanence

    There is massive deflation EVERYWHERE. Subtract out the trillions central banks have thrown at it to understand the actual levels. Unless this entire system collapses, deflation will be with us for many years to come.

  8. Oregoncharles

    Remember, lenders (capitalists) BENEFIT from deflation. They get back more than they lent. They also benefit, even more directly, from driving or holding down wages.

    So the point of the article (and the conclusion of the study it’s based on) is that the “labor market rigidity” theory is just propaganda to serve the plutocrats’ selfish, short-term interests. Short term, because they also lose when economies collapse.

    Just because they’re rich doesn’t mean they’re smart, let alone wise.

  9. Synoia

    “aggregate demand is the solution” – you mean paying customers.

    Which would require the customers having the means ($ or E) to buy stuff….

    With all the increase in wealth going to the 0.01% (through the lower 99.99%’s debt service) where is the “increase” in the 99.99%’s “means to buy stuff”….

    The argument is self defeating.

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