The euro zone has struggled mightily in recent years, with its economy shrinking in both 2012 and 2013. Now it faces a new worry. Inflation in the euro zone has fallen to a 0.4% annualized rate, well below the target of close to 2% set by the European Central Bank (ECB) and close to outright deflation. The dangers of high inflation (a sustained rise in the prices of goods and services throughout the economy) are well known: it reduces the value of people’s savings and can make individuals and businesses reluctant to invest. So shouldn’t deflation (a decline in prices) be beneficial? Not exactly.
There are a number of ways that deflation harms an economy. First, since the amount owed on loans and bonds stays the same even if the price of goods and services decline, deflation can make it more difficult for individuals, businesses, and governments that have borrowed money to get out of debt. Just as inflation hurts bondholders, deflation hurts debtors.
Second, it tends to be easier for companies to raise wages than to make their employees take pay cuts. Therefore if prices are declining so companies can’t pay their workers as much, they are likely to lay off more employees, leading to higher unemployment.
Third, when people see prices falling they may respond by postponing their purchases until prices go down even further. A decline in prices can therefore lead to reduced demand, causing further price declines (a “deflationary spiral”).
The euro zone may already been feeling some of these effects, since they can start to kick in when the inflation rate is persistently low, even if it’s still above zero.
Unlike the central banks of other developed countries such as the US, UK, and Japan, the ECB hasn’t engaged in “quantitative easing” (essentially creating new money and using it to buy bonds). This difference is one reason why expected future inflation is now substantially lower in the euro zone than in the US or UK. To avoid the perils of deflation, the ECB may need to take more aggressive action to prop up the continent’s economy.