What if the Euro Area is Led to Serious Deflation?

Philip Arestis and Malcolm Sawyer

The economies of the euro area monetary union are close to deflation. In May 2015, the annual rate of inflation averaged 0.3% across the euro area, after six months during which the rate of inflation had been zero or below. The question then arises as to whether the deflation has been internally or externally generated, whether it becomes self-perpetuating, and what the consequences would be.

The dramatic drop in global oil prices have had a significant effect in the reduction of the rate of inflation, though with some recent rises, this dampening effect on inflation may have come to an end. The threat of zero or negative inflation means that households and firms, which are heavily indebted, find it difficult to service their debt, partly because its real value increases with falling prices and also because current household income is falling and firms are reluctant to invest in view of expected falling demand.

Deflation could well compound the lack of aggregate demand which stalks the euro area. The strategy of the euro area to reduce unemployment is based on a twin track approach of reducing budget deficits based on a belief in “expansionary fiscal consolidation,” and reinforcement of so-called structural reforms to make labour and product markets more “flexible.” But structural reforms and improving competitiveness entail flexible labour markets, a lower minimum wage, less labour job protection, and a strategy of wage cuts as a way forward.

Surely, though, a successful implementation of these policies would result in lower aggregate demand and lower wages. Consumption, the largest component of aggregate demand, would tend to decrease, being closely linked with wage income. Much reliance is placed by policy-makers on a boost to investment coming from the reduction of budget deficits and lower wages. But the outcome is more likely to be lower investment as aggregate demand is adversely affected. Exports could be aided through lower prices, but much would depend on the response of the euro exchange rate such that the export prices in, say, dollars would change little. In any case, exports by the euro area as a whole are a relatively small proportion of GDP.

One of the arguments for “structural reforms” to create “flexible labour markets” is that “inflexible labour markets” mean that a stimulus to demand (e.g., coming from a reduction in interest rates) is swallowed up by wage and price rises with little effect on output and employment. This is explained by the existence of labour market rigidities, which, in the words of the ECB (2004), “limit the pace at which an economy can grow without fuelling inflationary pressures” (p. 21). Thus, if the ECB lowered the rate of interest in an attempt to expand economic activity in the euro area economy, this would merely be translated into higher prices with only limited effects on real economic activity.

This is the ECB-handicap hypothesis (Angeloni et al. 2003). In terms of labour market reforms, this hypothesis suggests that labour markets should become more flexible if more jobs are to be created, which would promote growth. Available evidence, however, suggests that these reforms are not important in creating jobs and promoting growth. Inflexible labour markets do not appear to be as important as insufficient aggregate demand in explaining the euro area’s inability to increase income and employment. If at all important, they are so in the long run.

De Grauwe and Costa Sorti (2005) investigated the ECB-handicap hypothesis. The authors of this study utilise a “meta-analysis,” which aims first to “statistically analyse the estimated effects of monetary policy shocks on output and prices, and second to identify the factors that can explain the differences in these estimated effects” (p. 4). They employ 83 studies, which report on the impact of interest rates on inflation and output. Four different parameters that measure the effect of monetary policy are examined: short-term effects on prices and output; and long-term effects on prices and output (effect after one year measures the short term; effect after five years measures the long term). Since many of the 83 studies employed report results for more than just one country, 278 parameters that measure the short-term and long-term effects on output are obtained, while only 185 parameters are possible to obtain for the short-term and long-term effects on the price level. An econometric equation explaining these different parameters is employed. The purpose is to control for a number of variables that can affect the size of the estimated coefficients (different estimation methods, different time periods, etc.).

It is concluded that, for the euro area, like for the United States, that the short-term effect on the price level is very small, while the long-term effect on prices is significant. Short-term and long-term effects on output are significant. The ECB-handicap hypothesis is, thus, not upheld. It is, thus, not the case that the ECB cannot affect output because of the existence of rigidities, especially in the labour markets.

We may therefore conclude that the key to avoiding deflation in the euro area, and elsewhere, is not to introduce structural reforms. It is, rather, a solid growth of domestic demand. A stable and healthy wage growth that would encourage consumption and thereby aggregate demand is the solution, rather than structural reforms.


Angeloni, I., Kashyap, A., Mojon, B. and Terlizzese, D. (2003), “The Output Composition Puzzle: A Difference in the Monetary Transmission Mechanism in the Euro area and the US,” European Central Bank Working Paper Series No. 268, September, Frankfurt: European Central Bank.

De Grauwe, P. and Costa Storti, C. (2005), “Is Monetary Policy in the Eurozone Les Effective than in the US?,” CESifo Working Paper No. 1606, November.

European Central Bank (ECB) (2004), Monthly Bulletin, June, Frankfurt: Germany.

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One Response to “What if the Euro Area is Led to Serious Deflation?”

  1. […] Yves here. This post explains indirectly why one of the “reforms” that the creditors have been insisting that Greece implement is “liberalizing” the labor market, which is bureaucrat-speak for squeezing workers. Astute readers will notice that the logic is based on the loanable fund model, which we’ve been debunking every time a good paper or story gives us an excuse to return to that theme (see this post for a recent discussion). By Philip Arestis, Professor of Economics at the University of the Basque Country, Spain and Malcolm Sawyer, Professor of Economics, University of Leeds. Originally published at Triple Crisis […]