A specter is haunting Europe -- the specter of deflation. Countries throughout the European Union have been struggling for the past several years with stagnant or falling prices. In Hungary, inflation has fallen to its lowest level since 1974. In Bulgaria, Cyprus, Greece, Ireland, and Latvia, consumer prices fell on a year-over-year basis in 2013. Over the same period, consumer prices remained static in Portugal and Spain, and they rose by the statistically insignificant rate of 0.5 percent in Denmark, Lithuania, Slovakia, and Sweden. Aggregate inflation in the EU has declined to a five-year low of 0.5 percent, well below the target of two percent set by the European Central Bank (ECB).
As long as incomes remain stable, deflation has a positive impact on consumers’ purchasing power; they can buy more goods and services as prices fall. Their savings also increase in value as prices decline, unless banks begin to charge negative interest rates -- basically, a fee for holding money. But deflation can be devastating for citizens with loans: as the value of their money remains stagnant or even decreases, they must continue to meet their debt obligations, the nominal value of which does not change. At the same time, whatever assets they have pledged as loan collateral decline in price, prompting lenders to demand further security against default. Deflation is also bad news for individuals and companies who do business across borders. Imports may become more expensive, and exports can generate lower revenues. Deflation also threatens citizens and companies with loans and other credit facilities.
For evidence of the ill effects of deflation, look to Japan in the 1990s, which closely resembles Europe today. There, too, the financial sector struggled under a large burden of bad loans. Like Europe, Japan also faced an aging population that consumed less. Another disquieting similarity is that the ECB, like its Japanese counterpart, seems unwilling to dramatically counteract these ominous monetary trends. The ECB has some reasons for its reticence -- but they aren't good enough.