The Eurozone has been on the brink of deflation for months. The latest data show that for the first time, consumer prices for the currency area as a whole (and for 12 of its 19 member countries) were actually lower in December than a year earlier. But is it “real” deflation?
In a pair of posts   last fall, when EZ inflation was merely low, but not yet negative, I explained that there are two kinds of deflation.
nasty kind of deflation, which everyone rightly fears, is driven by
falling aggregate nominal demand. As demand collapses, it drags both
real output and the price level down with it. There is a serious risk of
a self-reinforcing downward spiral in which debtors can’t repay their
loans, defaults and falling asset prices undermine the financial system,
zero interest rates render monetary policy powerless, and rising
unemployment sparks social unrest.
However, there is also a benign
kind of deflation, driven by rising productivity. In that scenario,
conservative monetary policy restrains the growth of nominal GDP while
real output surges ahead. The rate of inflation is negative, but growing
output provides borrowers with the cash flow they need to repay their
loans, rising productivity allows real wages to rise, and nominal
interest rates, although low, do not need to fall all the way to the
zero bound. In the US and UK, such productivity-driven deflation was the
norm during much of the nineteenth century and reappeared again, more
briefly, in the prosperous 1920s.
So which kind of deflation is
Europe facing now? The bad, demand-driven kind, or the good,
supply-driven variety? A little of each, it seems. >>>Read more
Follow this link to view or download a slideshow-tutorial, "Why Fear Deflation?".