Does deflation or inflation pose the biggest threat to Portugal?

If there is one thing guaranteed to strike fear into economic policy makers, it is mention of the dreaded D word. Deflation occurs when prices in general fall for a prolonged period of time and its spectre gives central bankers nightmares because deflation is so hard to reverse and its effects can be so deadly.

People cut back on their spending because they know prices will be lower in a week, a month or a year. Why would you buy a car, a mobile phone, or a washing machine, for example, today when you know it will cost 5% less in a few months’ time? That, of course, means demand across the economy falls and unemployment rises. An economy can soon enter a vicious downward spin with an economic depression the inevitable result.

Inflation is the opposite of deflation and occurs when prices across the economy rise for a sustained period. Inflation is generally regarded as being quite healthy if it is contained at relatively low levels, but if it takes off into double figures, it can also prove very harmful, although perhaps not as deadly as deflation.

Central bankers are paid to worry about both inflation and deflation and to devise and implement policies that avoid both. But they have seldom had to worry about inflation and deflation at the same time, at least until now. For we appear to be in a strange new world where for every analyst arguing that inflation poses a serious threat, you can find another arguing the greatest danger comes from deflation.

The paper tiger of inflation
Those who claim inflationary pressures are building can point to the huge sums of money being created and injected into economies and financial systems by central banks via quantitative easing (QE). QE was an emergency measure adopted in the wake of the global financial crisis of the last decade and used to stimulate economies and prevent them from tumbling into deflationary spirals. The belief that QE would result in inflation stemmed from the theory that if you increase the amount of money circulating in an economy that will inevitably force prices up.

Many people warned a decade ago that QE would lead to hyperinflation. Kenneth Rogoff, an economics professor at Harvard University and former chief economist of the International Monetary Fund, argued in 2009, for example, that annual inflation could go as high as 8% to 10% within three to five years in the US, and sooner in the UK.

Yet inflation has remained at very low levels for much of the past decade even though, far from being an emergency measure, QE has become an almost permanent feature of economies. Indeed, the printing presses have been churning out money at an ever faster pace this year because of the Covid-19 pandemic.

True inflation has increased in the USA, but, in Europe, prices are falling with eurozone inflation running at -0.3 per cent in September. Moreover, inflation has been very weak in Europe for a decade or so. The European Central Bank, for example, aims to keep inflation at just below 2%, yet price rises have fallen short of that target for most of the past decade.

Deflation poses a particularly dangerous threat to highly-indebted countries like Portugal. That’s because inflation is friend of debtors who can rely on rising prices to reduce the real cost of their debt until it practically disappears. Imagine a country has debt equivalent to 100% of its GDP, while inflation rises to 5% per annum. The face value of the debt will remain the same but inflation will ensure the economy grows by at least 5% a year. Add in another 2-3% of economic growth and the debt begins to fall fast.

The reverse is true of deflation. The real cost of the debt remains the same while the economy shrinks as do government revenues making it ever harder for a country to pay the interest and principal of its debt. As the American economist Irving Fischer explained during the Great Depression of the 1930s: “Each dollar of debt still unpaid becomes a bigger dollar, and if the over-indebtedness with which we started was great enough, the liquidation of debts cannot keep up with the fall of prices which it causes. In that case, the liquidation defeats itself.” In other words, debt simply overwhelms the economy.

Is Portugal heading for a deflationary trap?
There are worrying signs that deflation is getting a grip in Portugal with prices falling by 1.3% in July. That is unsurprising, given the economy is facing one of its worst economic downturns in decades with the central bank forecasting a contraction of around 8% this year.

So, what can be done? The answer must lie with the European Central Bank. In September, the bank said it would consider following the lead of the Federal Reserve, the US central bank, by committing to let inflation overshoot its target, a tacit admission that the ECB is concerned by the threat of deflation.

Analysts are already betting this means that interest rates will remain at very low levels for much longer than was previously expected. Moreover, the printing presses could well pick up speed as the ECB adopts ever larger programmes of QE to prevent the eurozone from plunging into recession. We have to hope its efforts will be successful because the consequences of failure for Portugal and the global economy are too awful to contemplate.

By Anthony Beachey
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Anthony Beachey is a former BBC World Service journalist now working on a freelance basis in Portugal, where he specialises in economics and finance.