Greek Canary In Europe's Deflation Coal Mine

by: Desmond Lachman

This morning the Greek statistical agency reported that the pace of consumer price deflation in Greece has now picked up to 2.9% in November 2013. This puts Greece firmly into deflation territory, which will highly complicate the country's efforts to engineer an economic recovery or to bring its public debt down to a more sustainable level. As such, it should be raising a red flag in Europe about the risk that other countries in the European periphery will also drift towards outright price and wage deflation. For much like Greece, Ireland, Italy, Portugal, and Spain all have very large labor and output market gaps. And these gaps, which are unlikely to be closed anytime soon, are occurring at a time when these countries are already in or else on the cusp of deflation.

Sadly, there is very little prospect of decisive policy action to avert the danger of the European economic periphery from slipping into outright deflation from either the European Central Bank or from the policymakers in Berlin. Indeed, some of these policymakers seem to welcome deflation in the European periphery as a means for these countries to regain lost international wage and price competitiveness. In so doing, they choose to gloss over the real obstacles that deflation poses to economic recovery and the damage that deflation wreaks on those countries' public and private sector debt dynamics.

A key point that overly complacent European policymakers seem to downplay is the very high level of both public and private sector indebtedness in Europe. Leaving aside the egregious Greek case where public debt exceeds 160% of GDP, in Ireland, Italy, and Portugal, public debt is already in excess of 125% of GDP. Meanwhile the level of private debt in countries like Ireland, Portugal, and Spain now exceeds 200% of GDP, or around double the corresponding US number.

As Irving Fisher pointed out during the US Great Depression, falling prices increase the real burden of public and private debt. That in turn reduces households' willingness to spend at the very time when the economy most needs such spending. European policymakers would seem to be making a major error in downplaying the risk that the European periphery is heading towards a deflationary trap. One has to hope that Greece's rapid descent deeply into deflation territory will soon shake them out of their present complacency.

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