The eurozone is in deflation. It's official.Inflation's fall into negative territory was confirmed Wednesday, with consumer prices down -0.2% in December. Analysts have been fretting about it for months, and it's likely to get worse in the coming months.But why does it matter' It's hard to convey that falling prices can be a bad thing, since they seem like such an obviously positive thing in everyday life. But there's an extremely negative side to deflationEconomists sometimes say "don't reason from a price change" for this reason. If a price falls, that could be because the supply of something is going up. If farmers produce twice as much food on the same amount of land, the price is likely to fall but nobody really loses out, as long as it all gets bought.But pricesalso fall because demand for something is going down.So if the farm produces the same amount of food but consumers can only half as much, he'll have to cut prices too. This type is not obviously so great. The farmer certainly isn't a fan.It's also complicated for Europe because it seems very much like the region has both types right now. Demand is quite severely depressed, but the plunging price of oil is what pushed inflation into negative territory today. Of course, oil could also be falling in part because of low demand, making things even more complicated.In a note today, Capital Economics has helpfully laid out the three major challenges coming from deflation (especially the demand-driven type):1.) The rising burden of debt:"Rather than simply boosting spending power, falling prices may lead to outright declines in nominal incomes ' including wages, profits and government revenues. This in turn will increase the burden of servicing debts, which are typically fixed in nominal terms."It's easy to see this: imagine prices falling in a shop, which has a mortgage to pay. They have less money coming in, but their mortgage stays the same. Less VAT from their sales goes to the government, and perhaps less income tax, if they can't employ as many people or can't raise their wages. The government has fixed debts too, which start to seem larger. 2.) Asset prices could fall too:In Japan, deflation wasn't restricted to consumer goods. When land prices fell, so did the assets that businesses held, again when compared to their debts. Companies could then use their cash flows to try to pay down their existing debts, money that they then cannot use to hire, or invest, hitting economic growth.3.) It becomes a self-fulfilling cycle:"This could encourage households to delay spending, in the hope that they will eventually be able to buy goods more cheaply. It could also prompt companies to cut back investment, for fear that future returns will be lower."As you can see from the chart of eurozone inflation above, most people don't expect that the eurozone will stay in deflation for a prolonged period. Crucially, core inflation, which strips out volatile items like fuel, isn't expected to fall below zero. This is the most important risk from the European Central Bank's perspective. They haven't hit their inflation target for nearly two years, but have repeatedly explained this by saying that "inflation expectations are well-anchored".Businesses won't be bothered with a little bit of deflation if they think it's temporary: They have to plan years into the future. But if they think deflation is going to go on and on, they may well hold off. And by holding off, spending falls, and that lower demand helps to keep prices falling. This is the way that even gooddeflation, caused by rising supply, can be bad.But six months ago, it wasn't a mainstream suggestion that Europe would fall into deflation, and people didn't expect Japan to see decades of falling prices. And what's worse, it's not at all clear what the eurozone can or will do about it. Some of the deflation may be down to the fact that Europe's population is simply ageing, and that's naturally deflationary.The eurozone's fiscal compactprods states to run a budget deficit of no more than 3% of their GDP. This means that even with deflation, most countries are still trying to cut their deficits, compounding the problem. Germany, which has now balanced its budget, could stimulate and still be within the rules, but the government doesn't seem to be interested.So the eurozone has effectively outlawed Keynesian responses. Even monetarist responses, which rely on the central bank, are much slower and seemingly less effective in Europe. The European Central Bank has been behind the curve in pretty much every decision it's made in the last seven years. It raised interest rates in the summer of 2008, just before the worst of the financial crisis, raised them again in 2011 and strangled a feeble recovery, and is only now on the verge of large-scale asset purchases (quantitative easing), about six years after the Bank of England and Federal Reserve.QE could stimulate the eurozone, but given the ECB's record, it's hard to be optimistic. If Europe does see a prolonged bout of deflation, the continent has very little in its arsenal to fight it with.Join the conversation about this story
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