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Wednesday, 14 January 2015

There is deflation in the European Union...officially, under influence of the oil price. While the energy prices are an exceptional circumstance currently, the writing with respect to deflation has already been on the wall for quite some time.

One of the most heated and divisive debates during the last few years has been the hyperinflation versus deflation debate, among economists and pundits. 

In a nutshell, the discussion was about this: would the European Union become subject to the Japan scenario of low growth, low interest rates and extremely low inflation? Or to the contrary: would the massive influx of extra liquidity through the European Central Bank lead to a situation of hyperinflation. 

By many, this discussion has been encountered in the same way as a religious conflict within the catholic church, about the right path to follow for salvation. 

The main protagonists from both sides often categorically refused to look into each others statements, motivations and research results, but kept banging the drums of their own opinions instead; even if these opinions were over and over again repudiated by the statistical data from the national statistical bureaus and Eurostat.

So it could happen that, while the official European and national inflation rates (in The Netherlands and almost all other European countries) already showed a downward trend for months and months in a row, the defenders of the hyperinflation theory would argue that this was only a temporary illusion that would not stand its ground in the very near future. Until now - well over one year later - these defenders have been blatantly wrong and there is no sign of dramatic change underway.

In the vision of the hyperinflationistas, the excess liquidity and the extremely low interest rates, enabled by the European Central Bank, would inevitably lead to strongly elevated inflation (superinflation), perhaps even hyperinflation. 
By itself this is no erratic concept at all, as this would probably indeed happen under normal circumstances in a 'normally functioning' economy, in which the consumer and investors confidence would be at normal (or elevated) levels and the banks would be healthy, well-funded institutions without a worry in the world. But this isn't a normal economy and it has not been that since 2008 ...

The most important thing that these hyperinflationistas didn't process into their statements, opinions and research was the circumstance that this excess liquidity of the ECB never really seeped through to the real economy, in the form of extended loans and creditlines for small and medium enterprises and higher wages and fees for ordinary lower and middle-class workers and freelancers. 

Especially the latter category of workers became a "victim" of the ubiquitous pressure on tariffs and fees, due to a large influx of workers from the low-wage countries India, China and the countries in Eastern Europe, as well as a lack of new assignments that could lead to higher demand for freelance workers. 

Building projects and projects in the ICT industry, as well as the requirements for temporary workers in the commercial and financial services industries, were all at minimal levels: in most cases only the necessary projects and activities were executed, but not very much more. And where ICT projects in the financial and commercial services industries did generate a substantial number of new jobs, the same number of jobs or even more were abolished at the labour-intensive service departments. ICT projects should save jobs and save money: not expand the number of jobs.

Instead, the ECB liquidity money was hoarded by banks for the purpose of balance sheet improvement (i.e. solvency and liquidity improvement) and used by large, multinational companies for share buyback programs, as well as mergers and acquisitions(!)), or reinvested for the purpose of making lucrative carry trades. None of these actions led to a dramatical seeping through of liquidity to private consumers and SME enterprises, especially as the banks saw few possibilities for succesful investments in the retail industry and other SME companies. Insteady, the banks sat on their cash.

So the strange situation occured that (very) large companies, hedgefunds, large investors in stocks and especially the large banks were almost swimming in stockpiles of cash, while normal citizens, as well as SME-companies and retailers became strapped for cash, due to the ubiquitous wage restraint, soaring taxes and levies from the cash-strapped governments and credit lines further drying out. It became in fact the perfect wishbone society.

In my vision, hyperinflation can never occur in a situation in which the credit supply to small and medium enterprises is restrained and wage development is extremely limited, under normal circumstances. That simply does not match: when people and SME companies - of which there are most in a country or community - keep roughly the same amount of spending money for consumption and investments and there are no dramatic price increases on any imported goods whatsoever caused by influences from abroad, then hyperinflation is almost impossible to occur.

That is, unless... a country or community as a whole suffers from a strong depreciation of its national or shared currency. Especially when it requires large amounts of expensive imports of basic and luxury goods, agricultural produce and services, for which it cannot compensate with exports anymore. This is exactly what happened in Russia a few weeks ago.

Russia is a country that is traditionally very dependent on the export of oil, gas and other commodities for its economic wellbeing and Gross Domestic Product. 

Except for the flourishing weapons industry, many production industries (cars, machines, furniture, tools, semifinished products, home appliances, clothing and shoes), as well as the agricultural industry, merely lead a lingering existance in Russia or have even almost vanished, due to obsolescence; unable as they are to produce goods and produce that can compete with the quality, looks and/or price of Western and Far Eastern goods, produce and semi-finished products. 

Other industries, like the commercial and financial services industries, have not yet been developed to a scale and level to which we are used in the Western and Far Eastern world, in order to make a big impression on the international markets.

When (as it has been happening in the period from December 2014 - January 2015 ) the prices of the main export products (oil and gas) plummet, the earning capacity and GDP of this country and thus - in the process - the creditworthiness will plummet too. As a consequence, the rate of the national currency will inevitably drop, as it becomes 'less competitive' in comparison with other currencies. This was in my opinion the reason that the national curency (i.e. the ruble) made a skydive in December.

Then the situation occured that the very necessary imported goods, services and agricultural produce all kept the same price level in dollars, yens, yuans or euro's, while at the same time the purchase power of the ruble had dropped to the bare minimum. 

Hence: enormous inflation of over 10% within a few days and consumer prices that changed by the hour were the (temporary) effect, that in the case of Russia could only be decellerated by a dramatic raise of the most important interest rates to 17%. By the way: I rather call this superinflation and definitely not 'Weimar-style' or Zimbabwean hyperinflation, which was a totally different ballgame.

None of this, however, is going on within the European Union and the Euro-zone, in which the Euro is still a rock-hard currency. The Euro did hardly give in in the past months, in spite of the Greek and Italian economic challenges and the constant quarreling between the North and South European countries on one hand and the EU and the United Kingdom on the other hand. 

The EU economy as a whole, as well as the individual countries, remained roughly at the same level of either very reluctant growth or even (minute) decline. Some countries did slightly better than others and showed some cautious growth, while other countries showed less positive achievements (Greece, Italy). Nevertheless, the EU economies combinedly operated at a fairly stable, low level of economic growth.

In general, nothing happened out of the ordinary: there was neither a positive impulse in the credit supply to SME companies and retailers, nor dramatic investment wave among multinationals and large companies. There were no other significant, economic impulses, no national and international Keynesian state aid programs and investment plans, no significant tax-decreases and - most important - no dramatic wage increases for lower and middle-class workers and freelancers. 

In other words: there was no reason whatsoever for the current deflationary trend to make a turnaround and hence, this did not happen.

The following publication comes from Eurostat:
Euro area annual inflation down to -0.2%

The Euro area annual inflation is expected to be -0.2% in December 2014, down from 0.3% in November, according to a flash estimate from Eurostat, the statistical office of the European Union.

This negative rate for euro area annual inflation in December is driven by a fall in energy prices (-6.3%, compared with -2.6% in November), while prices remain stable for food, alcohol & tobacco (0.0%, compared with 0.5% in November) and non-energy industrial goods (0.0%, compared with -0.1% in November). The only annual increase is expected for services (1.2%, stable compared with November). 

The Euro Area annual inflation for December 2014
Data courtesy of Eurostat
Click to enlarge

The Euro Area annual inflation and its
components for December 2014
Data courtesy of Eurostat
Click to enlarge

Of course, one has reasons to argue in this situation that the enormous decline of -/- 6.3% in energy prices has an extraordinarily strong influence on the current deflation in Europe, as it is probably almost fully responsible for this small deflation percentage of -/- 0.2%. 

Still, I could justifiably reply that the drop in oil prices would not have been that big when the demand for oil and oil derivatives would have been at an elevated level: a certain sign of a strong economic improvement, with increased production levels. The fact that the demand for oil is (much) smaller than the current supply is a deflationary signal in my humble opinion; not an inflationary.

Although The Netherlands has still a very strong economy and is currently indeed showing some signals of cautious, economic improvement (especially in the area of flexible employment in the financial and commercial services industry), the previous trend pointed towards very low inflation/deflation is still very much present in The Netherlands.

See the following two publications by the Dutch Central Bureau of Statistics:

Statistics Netherlands: Inflation in December down to lowest level in more than 5 years
  • Inflation in December down to 0.7%
  • Cheaper motor fuels have downward effect on inflation
  • Eurozone inflation rate down to - 0.2%
Statistics Netherlands announced today that inflation fell from 1.0% in November to 0.7% in December, the lowest level since October 2009. The low rate was mainly caused by declining petrol prices.

Just as in November, lower motor fuel prices pushed down inflation in December. For the third month in a row, fuel prices at the petrol station have fallen substantially. In December, the price of a litre of unleaded petrol averaged 1.55 euros, i.e. 0.14 euros below the level of one year previously. The average monthly price level of petrol has not been this low since November 2010. Price developments for food products also pushed inflation down; in December, the average price of food products was lower than in December 2013.

The inflation rate over 2014 averaged 1%, which is significantly lower than the average rate of 2.5% over 2013. The average inflation in 2014 is the lowest in more than 25 years. In 1988, the rate averaged 0.7%.

Dutch inflation according to the HICP has fallen to - 0.1% in December. Yesterday, Eurostat announced that the inflation rate in the eurozone stands at - 0.2%, i.e. 0.5 percentage points below the level recorded in November. A negative inflation rate also occurred in 2009. Then, too, the negative rate was caused by low oil prices.

And the following publication was even more dramatic:

Statistics Netherlands: inflation rate 2014 lowest in more than 25 years

Statistics Netherlands announced today that the average inflation rate over the year 2014 was 1 percent. The price increase for products and services Dutch consumers bought last year is the smallest increase in more than 25 years. 

Prices of many products and services have hardly risen last year, but rents rose rapidly in 2014.

Following a period of high inflation, the rate over 2014 was exceptionally low. The inflation rate over 2013 averaged 2.5 percent. In 2013, inflation was seriously affected by tax increases. The inflation rate over the past 25 years averaged 2.2 percent.

Dutch Inflation in percentage
Data and chart courtesy of: Central Bureau of Statistics
Click to enlarge

The residential rent increase  contributed most to inflation in 2014. The average rent increase was more than 4 percent in 2014 compared to 2013. Higher tax rates also contributed to inflation. Road tax, for example, was raised considerably in January 2014. If rent and tax increases are not taken into account, the inflation rate would be -0.1 percent.

Inflation was curbed last year because gas, electricity and motor fuels became much cheaper. Energy prices are strongly affected by developments on the global market. Therefore, inflation is often calculated excluding volatile energy prices. In 2014, the gap between these two benchmarks averaged 0.2 percentage points. In the latter half of 2014, the gap widened to 0.5 percentage points as a result of rapidly declining oil prices.

Inflation and inflation excl. energy in percentages
Data and chart courtesy of: Central Bureau of Statistics
Click to enlarge
Prices of many products and services remained stable in 2014. As producers did not raise their prices and collectively negotiated wages rose only marginally, there was no reason for a significant consumer price increase.

During the recent economic recession, the collectively negotiated wage increase has been below the level of inflation, but when inflation started to fall, the gap between the collectively negotiated wage increase and inflation narrowed. If collectively negotiated wages increase or decrease, this will not have an immediate effect on the purchasing power of employees. After all, net wages also depend on changes in social contributions, contributions to pension funds and wage tax. 

Inflation and collective wage increases (CAO) in percentages
Data and chart courtesy of: Central Bureau of Statistics
Click to enlarge
The conclusion must be that the general trend in The Netherlands and the European Union in general is rather deflatory than inflatory.

Yesterday, I read some tweets from Dutch economists about helicopter drops of money within the European Union, which should be initiated by Mario Draghi of the European Central Bank. This, in order to fire up the European economies and raise the inflation rate. 

Two things about that concept: 

  • a. I don't think that this will have a dramatic effect on consumption, unless it will be a dramatic amount of money per household. The chance that people will save it as a nest egg for a rainy, or pay a few bills-in-arrears with this money, is bigger than that people will start a shopping spree with this money.
  • b. Such a plans will most probably be slaughtered by the ever-cautious Germans, who still suffer from their post-Weimarian nightmare and never would also such drastic monetary policies.

I think that the deflationary trend is here to stay for another while. And so are the very low growth, the cautious wage development and the extremely low interest rates in The Netherlands and most other European countries, except for perhaps Greece, Italy and France.

This means that the Japan scenario is still very much in play and the economic crisis might linger on for the next decade or longer, unless something dramatic happens!

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