Cyprus Mail

Serious downsides to deflation

Ben Bernanke, the chairman of the Federal Reserve

By Paul Rowland

Deflation shouldn’t be a problem. After all we were led to believe inflation was the real evil, eroding the value of savings and making life more expensive. But in a deflationary environment, if you are in debt or have a mortgage you have a real problem because your income is falling together with the value of your collateral/property, but the amount of your debt does not reduce.

In Cyprus as the economy contracts, because of the recession and the austerity programme imposed by the troika, salaries are reduced (if you still have one), prices fall and the economy is deflating. However debt, both household and government, remain the same, but servicing that debt takes a greater share of income or GDP.

The only winners in a deflating economy are those people fortunate enough to enjoy a secure income (pension?), savings and very little debt. On the other hand, inflation increases the monetary value of real assets and erodes the value of the debt.

It is not just households that suffer; indebted governments are vulnerable to deflation as lower inflation will increase debt-to-GDP ratios, which is a key indicator used to measure a country’s debt burden. And of course governments are subject to the same economic constraints as individuals and companies.

The problem is not confined to Cyprus, it is global. Japan has had 20 years of deflation with no growth and there are real fears that the eurozone may follow.
comment paul - table for cyprus inflation

In October Cyprus inflation was -1.6 per cent and European monetary union-wide inflation 0.7 per cent, year on year. Both charts show the declining trend over the past two years and the Cyprus chart reflects the sharp contraction in the economy since May of this year.

In 2002, six years before the current crisis, outgoing chairman of the US Federal Reserve Ben Bernanke described the problem.

“Deflation is in almost all cases a side effect of a collapse of aggregate demand – a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers,” he said. “Likewise, the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending – namely, recession, rising unemployment and financial stress.”

The European Central Bank (ECB), based in Frankfurt, recently cut interest rates to a record low of 0.25 per cent. Mario Draghi, the bank’s president commented: “We may experience a prolonged period of low inflation.” But many leading economists think the ECB may have done too little or not addressed the real problem of how to strengthen the European monetary union economy.

François Heisbourg, head of the Geneva International Institute for Strategic Studies, is one of them.

“Britain, the US, Japan, all have a strategy of monetary stimulus, but in the EU we have nothing but hard money. The currency doesn’t belong to bankers, and it doesn’t belong to Germany, it belongs to all members of the eurozone,” he said. “We must face the reality that the EU itself is now threatened by the euro.”

Why are the Germans so intransigent about stimulating the eurozone economy? The reasons go back to the hyperinflation the country experienced in the 1920s which left national scars that remain even now. Fear of inflation is embedded in the psyche of the nation and German politicians and economists are obliged to endorse economic stability.

There we have the crux of the euro problem. The one size, German economic policy, does not fit all members of the eurozone. In between times, the south suffers with recession, high unemployment and crippling debt. Falling prices are now starting to affect most eurozone countries including major economies such as France, Spain and Italy. However economic reality and political pressure is building within European monetary union for the ECB to act effectively and soon. Should the USA start to taper its quantitative easing programme the situation in Europe will turn very quickly for the worse.

The solution, no matter how much loathed by the Germans, has to be quantitative easing, fiscal stimulus and consequent devaluation of the euro. For countries like Cyprus devaluation of the euro would mean among other things; revitalisation of the main export, tourism, and an easier debt burden.

Paul Rowland is a founder member of a European consultancy for asset protection and debt management and former senior executive in international banking in the Channel Islands. [email protected]

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