Deflation has visited Japan for many years now, and is currently making itself felt in Europe. The rate of inflation in the Eurozone fell to –0.6% in January, which is an unwelcome development if we are looking to see the revival of the world economy . Much of this can be attributed to the fall in the price of energy over the second half of 2014. Some can also be attributed to the falling cost of food as a result of bumper harvests. The rest of our current deflation is attributed to deficiencies in demand, especially within the Eurozone. In may respects, this is a consequence of a policy of austerity.
Some politicians have triumphed deflation and very low inflation rates as a vindication of their economic policies. For example, George Osborne in the UK is reported as having said, "Inflation is 0.5% - lowest level in modern times. Welcome news with family budgets going further & economic recovery starting to be widely felt."  The Chancellor is almost certainly correct. Falling prices will help to make household budgets go even further. As Osborne’s deputy Danny Alexander put it, lower inflation was "like a giant giant tax cut for the economy" . In the normal course of events, a significant reduction in the price of energy, coupled with a relatively mild winter, should serve to boost household disposable income during the spring of 2015. As long as households spent this windfall rather than save it, we would normally expect one of the results of deflationary pressures to be an increase in economic activity as a result of increased household consumption. If this happens, George Osborne and Danny Alexander will be vindicated.
However, there are two clouds on the horizon. The first is that one person’s expenditure is another person’s income. If I buy a newspaper, the price of the newspaper is both my expenditure and the income of the newsagent. If prices are being squeezed at the retail end of the supply chain, then there is a danger that the deflationary pressure could be served all the way along the supply chain. We are starting to see this happen. As stated above, there is some downward pressure on food prices, and this is starting to have an effect on farm incomes. It is reported that milk is now cheaper to buy than water . Throughout the energy sector in the UK, investment plans are starting to be scaled back and parts of the workforce laid off .
This marks a rather dangerous point. If falling prices lead to falling incomes, and if falling incomes lead to the scaling back of employment, then we will have reached a very dangerous deflationary spiral. This is exactly what happened in the 1930s. If left unchecked, a bottom will be found, but at the cost of mass unemployment. Unless there are major changes to economic policy in the Eurozone, this is exactly where Europe is heading. As we have said before - thanks to Wolfgang Munchau - Europe is following ‘the wacky economics of Germany’s parallel universe’ . Recent events suggest that Europe will be locked into this deflationary spiral for some time to come.
The second cloud on the horizon relates to the cost of money. Nominal interest rates are at rock bottom levels – what economists call the lower bound (i.e. zero). Some monetary authorities have even set negative nominal interest rates (i.e. you pay the authorities to look after your money). However, it is not the nominal interest rate that describes the cost of money, the real interest rate does that. The real interest rate is the nominal interest rate less the rate of inflation. So, if the nominal interest rate is 5%, if inflation were to be 2%, then the real interest rate would be +3%. The cost of money to borrowers would be rising each year. Equally, if the rate of inflation were to be 9%, then the real rate of inflation would be –4%. The cost of money to borrowers, in real terms, would have fallen. The role of deflation is to accentuate the cost of money to borrowers. If inflation is –2% (i.e. we are in a situation of deflation), and if the nominal rate of interest is zero, then the cost to borrowers is +2%, in other words it is becoming dearer.
The rising cost of money as a result of an era of deflation is likely to dampen economic activity. The very households whose real disposable income has risen, if they are heavily indebted, might choose to pay down some of that debt rather than spend the money because the cost of that debt is rising in real terms. This form of disguised saving has the potential to nip in the bud the beneficial effects of falling prices. If it does so, then it has the potential to make the deflationary spiral much worse than it otherwise would have been.
Is deflation good for us? In some respects it is. It will lead to rising household disposable incomes, particularly for those who are disposed to spend their windfalls rather than save them. These are usually the poorest in society, who have suffered from fuel poverty in recent years. That is wholly beneficial. However, the silver lining also has a cloud attached to it. If falling prices lead to falling incomes and employment, then there is a danger that deflation will have a depressing effect on economic activity. If deflation really takes hold, then it may also lead to increased saving in the form of debt repayment, which will also have a depressing effect on economic activity and may serve to reinforce the deflationary spiral. This is wholly a detrimental effect, and can be seen within the Eurozone today.
It is too early to tell if we have more to gain than to lose from the current period of falling prices. We need to be vigilant of weak signals of an emerging future to see how things are likely to go. For example, we might like to take note of figures of credit card indebtedness to see if households are using the windfall of lower energy prices to pay down their debt. We might like to see if weaker incomes in the energy and food sectors have a knock on effect by reducing demand in those sectors which service these industries. If deflation is being passed on. We might like to see if either of these factors is having an effect on general retail sales. Is the windfall of rising household disposable incomes being spent or saved? Although the future is currently uncertain, signals about its progress will become evident in the months to come.
Only then will we know for sure if deflation is good for us.
© The European Futures Observatory 2015
 See: http://www.ft.com/cms/s/0/3172b7bc-a868-11e4-bd17-00144feab7de.html#axzz3Qyt7ZP75.
 The statements from George Osborne and Danny Alexander are reported in: http://www.bbc.co.uk/news/business-30794673.
 For some background to this see: http://www.theguardian.com/business/2015/jan/12/dairy-farmers-go-unpaid-milk-becomes-cheaper-than-water.
 See: http://www.bbc.co.uk/news/uk-scotland-scotland-business-30817678.
 See our piece on how Europe is on the wrong path: http://www.eufo.org/the-futurist-blog/the-fourth-reich.