Policy and Self-Fulfilling Prophecies

I've been raging about confidence for a while now. Since any other form of stimulus is either unproductive (e.g. monetary policy due to the ZLB) or infeasible (e.g. QE or government spending), the only way we could actually see growth in the region is via an increase in confidence, which basically means an improvement in our current expectations about the future. Simply put, if I am going to either spend or invest more, I have to know that I will continue to have a job in the near future or that the overall situation in the economy will be better than now.

The problem is that many of us (especially journalists) take a particular liking to bad news; it appears that they sell more than good ones and that is why we tend to emphasize on that (disclaimer: I may have fallen into that trap myself at times). This wouldn't necessarily be hurtful to the economy if we did not live in a world where we somehow create it ourselves. In physics, bad news about a specific group of atoms would not cause all other atoms to stop obeying natural laws. In economics though, bad news about some may cause others to react badly as well.

Think for example what happens when austerity measures on the public sector are imposed: although it may be right that some workers in some countries are overpaid, lowering their wages in a recession comes at a cost. As civil servants lower consumption, the private sector sees its demand fall and reduces investment, causing unemployment to rise. Then, until we adjust to the situation, the economy moves in cycles of reduced demand and investment, causing unemployment to rise and incomes to fall. In the Eurozone, we are now experiencing the time where most of the adjustment has already taken place and even though demand is weak and investment is low, we are much better off (expectations-wise) than a year ago.

Yet, some still point out to the bad things; while, for example, the outflow of deposits from Cyprus appears to be stabilizing with the overall amount registering ups and downs in the past couple of months (compared to huge decreases before), some focus on the downs. The problem of over-focusing on the bad news is that it creates another cycle of uncertainty, one which, on its own, can cause more damage than policies can. You see, if I am bombarded with constant emphasis on how bad the economy is doing (it's not doing good by the way but it does certainly fare better than last year) then I will be more than skeptical to invest or spend. The cycle, as described in the previous paragraph, is indicative of what will happen when confidence falls; the issue here is that over-exposure to "bad" news means that these will turn out to be true if people believe them to be. It is the equivalent of fiat money: it works just because you trust it, nothing more and nothing less.

This kind of over-emphasis can actually derail many of the countries already in a bail-out agreement. Biased information about Greece is what made Greeks believe that they are faring worse than expected, pushing the vicious cycle of austerity deeper into the economy. Now that they are faring much better, biased information and vastly exaggerated opinions are still appearing on popular websites. While I am certainly not a fan of irrational optimism (remember I was one of the first to note that the Cypriot economy was badly in need of a rescue package in 2012 and that Spain is not really out of its trouble) I do think that we should really think before we offer an opinion, especially if it is bound to affect millions.

The bottom line is simple: be very careful of the information you use to make decisions. Emphasis on what could go wrong never really helped anyone; and neither  it will in the future

P.S. As far as forecasts are concerned here are my own (obviously biased) ones: Greece will need no more loans after 2014, but she will most probably not exit the bailout programme by year-end as the Greek PM has predicted. Cyprus will have a tough year but it may actually show us some quarter-to-quarter growth in late 2014. Spain will be rather stable with a slight increase in GDP compared to last year but the big question is what will happen in Italy and whether Slovenia will opt for a bail-out. On the latter two we just wait and see.

We Can Have Growth But No Stability

One of the questions I have been asked lately was quite simple and yet it appeared rather hard to answer: "Why do we need growth every year? Why are economists so obsessed with growth and not with stabilizing output to approximately the same amount every year?" The question is usually asked by people who do not view capitalism as a good economic system but are too unwilling to make a change. As a former professor of mine once stated, the best thing in the world is to be a contrarian in a capitalist country; you get to keep both your money and your ideology.*

To be fair, economists do focus on growth. They do it because what they have studied has promoted them to think like that and they consider it so obvious that they waste no time in thinking on why it matters. In fact, we all somehow assume growth is good, we are just unsure why. The simple explanation is that growth is good since it creates more demand, more goods and most importantly more jobs and more money. This is a purely economical (and simplistic) explanation and one which will undoubtedly come under some criticism on the grounds of what people should really focus on or what they should do in their lives (which is really beyond the scope of this article). Still, as far as economics are concerned, growth is assumed to improve the well-being of every individual. 

Ideally, the best outcome of the combined action of policy and markets is full and stable employment. Yet, unless in the cases of war or re-building what the war has destroyed, we have never experienced full employment, and I doubt whether we could ever do that again (unless in wartime). The problem is that if we try to stabilize the system at a level far lower than full employment we would be having more unemployed than we could ideally have and this would create frictions in the markets. Stability would be meaningless if we have too much unemployment; simple logic states that we could do better by improving something. Nevertheless, even a stability scheme would not be sustainable even at full employment for the following reasons:

1. Changing population

Imagine that we have a country with a population of X million people of which Y are in the labour force (obviously Y<X). The unemployment rate is currently 0. During this time, aggregate demand is stable on average. Now imagine that the population rises every year. Unlike conventional economic models, real people do not start working as soon as they are born; they usually cannot do that until they reach a certain age. Thus, the family has to provide for their expenses, which means that although population has risen over time, aggregate demand is still the same as the family still gets the same income (inflation might cause income or demand to rise but this is not a real rise). Thus, assuming that the person will enter the labour force when he or she turns 18, as soon as that age is reached the person enters unemployment. The reason is practically simple: as long as you have stable demand you have no reason to increase your costs by hiring an extra person.

Now, let's assume that it's not just 1 person who enters unemployment each year but Z and they are in fact more than those who retire if we have a positive rate of population growth. Then, by the time firms realize that they have to employ more people to get more income, the number of unemployed increases. Given that such decisions about demand do not really come up so easily (and in addition, every other firm has to act the same way if they want to get back the amount they spend) and people are occasionally picky about what type of job they would like to do (the essence of search and matching theories) growth would be present and unemployment would fluctuate as population rises. 

2. The variable change in demand

In addition to the previous, demand is never stable even in case of full employment. As population changes, be it either growth or decrease, demand is altered every time. This is especially true of specific product demand. When demand is unstable, firms change output to fit it and thus both unemployment and total output fluctuates. Obviously, if the fluctuations are not large then there is no trouble in the system; unemployment may fluctuate but on average it will be stationary. Yet, if fluctuations are so large that the average cannot be maintained then we can forget about the system's stability.

Then question then becomes: why is demand so variable? Is it just because population changes or is there something else hidden behind it? The answer is both: increasing population leads to higher demand and falling population to less demand. Yet, as already stated, increasing population also comes with an increased unemployment rate until the new demand is settled in the economy. Although this may be considered as transitory unemployment, its duration cannot be specified. Decreasing population on the other hand presents the opposite: as demand is lessened, then firms have to scale down their production and thus unemployment is again increased. In both cases, it can be argued that the markets will work in such a way that unemployment rate will be stable in the long run; yet whether this really holds and how long is this long run is debatable.

3. Nature
Do you remember the last time someone predicted a flood? An earthquake? From what we know, nobody has, and it's quite doubtful if anyone will ever be able to do so. In fact, even if we were able to predict them, although human casualties would be minimal, material damages would still be large. We cannot move plants and other infrastructure as fast as we can mobilize people. Hurricane Katrina caused $81 billion of damages in 2005, with Hurricane Sandy causing an additional $68 billion in 2012. If we were in a system in which stability and predictability were the main characteristics then any deviation would wreck panic in the hearts of people. Which brings us to the most important of the factors:

4. Human Psychology
Recent experience indicates that people can either get excited too fast and too much about something (e.g. asset bubbles) or become afraid of something just as fast (market crashes). As the current system (or any system for that matter) functions with people acting within it, it is as stable as its constituent parts. Given that human behaviour ranges from one end of the spectrum to the other, how can we expect a system which is comprised of humans to be stable? More so, people, when acting in large groups fall victims of group psychology of either exuberance or hysteria much faster than when acting alone; in larger systems, the mood swings would be even greater, with larger consequences on them.

To illustrate this, think of person who is not really affected by austerity measures, or who is affected just a little bit. This person may believe that if his income is cut by 10% then he should cut his expenses by 15-20% so that he could save for a rainy day. Now imagine what happens in the economy when 10% of the population decides to do just that (for a tale on what happens this provides an example): demand falls, unemployment rises and a vicious cycle is initiated. This was one of the reasons austerity has not been successful; people fear about the future and tend to react strongly to an event.

Although some could argue that booms may increase demand by just as much crashes reduce it, the truth is that crashes do not really push it down that much. Although human beings are prone to large mood changes (just think of yourself: do you feel the same two days in a row? Doubt it. Most of the times we do not even feel the same in two consecutive hours) we are also prone to optimism and hope. It is against human nature to keep down and do nothing for a substantial period of time and that is how we got to develop from living in caves to exploring space. As Cullen Roche puts it, a measured optimist is the best world view.

Returning to the original question on growth and stability: we cannot stop growth and neither should we try to do so. It's what made us progress through the ages, what brought us the tools we are using now. Stability cannot occur in any economic system as long as it is run by people. Even in traditional economic modelling, population growth equals economic growth. If the system has what it takes to succeed then it will, no matter how many oppose it; if it does not the it will collapse sooner or later. Stability cannot be enforced on a system comprised by people exactly because people are unstable. While many economic models in the literature usually provide for a steady state in their analyses  they never take into account any shocks which could come from within the system, such as agent irrational behaviour or declining population.

The fact is, we need growth for stability as well as for incentives. If we are to grow with a stable rate of, say, 2% per year, then a shock which would contract GDP by 7-8% (note: this shock does not even count as a depression) would mean that we would face high unemployment and deteriorating social standards. Since we cannot eliminate the possibility of a large shock occurring all we can do to safeguard both ourselves and the economy from its impact is have as much growth as we possibly can, before and after the shock. The more growth we have before, the less destructive the shock will be and the less difficult it will be to overcome it and we focus on growth after its occurrence. We do not just aim for stability because stability provides no incentives to create, innovate and develop. For that, we need growth as we also want to be sure that when bad times come (and they will, for sure) we will be less affected by them.

To sum up, stability is something we cannot hope for in a human-based system, at least not in the way we commonly seek it. What we can do to make the most of it, is not criticize growth but try to stabilize that; this will act both as the prevalent force for development as well as a cushion for bad times.

*My personal view on the subject (in case anyone cared) is that although capitalism is the best system we have had until now (or better yet, the only one which survived) it still has plenty of room for improvement. We have gone a long way from the uncontrolled system in the early 1900's where the rich could practically manipulate everything they wanted. Nevertheless, the current system is far from perfect; we should aim for a better future by continuing to improve on our existing structure and not by demolishing it.

Work Hours, Job Turnover and Aggregate Demand in the US

It has been said that our perception of the world economy has changed. We are no longer constrained by limited goods like we did in the early- and mid-20th century; in fact, we have more goods than we have ever had in the past. Our economic understanding has shifted from supply problems to demand issues (not all economists adhere to this, but the flat earth society still exists doesn't it?) and our view of crises has been exactly that: a sharp drop in demand causes an abundance of goods and services remaining unsold, resulting in losses for corporations which, given their worsening economic situation have to let go many employees, if not all. This vicious cycle can be easily seen in any economy where austerity has been defining policy in the past couple of years with politicians unfortunately still adhering to flat-earth remedies (an excellent review of this shifting of ideas can be found in Tom Streithorst's Post-Scarcity Economics).

What has come to be an increasing worry is whether the US can really break out of the current secular trend of falling demand and continue on a path where demand is higher and more stable. In the case of the US, many appear to be pessimistic on whether this could be implemented. While others argue that the time of a permanent decrease in demand has come, others (like yours truly) believe that demand could actually be increased. Despite the camp the reader chooses to abide with the truth is that data are not so terrible as many present them. Job turnover has averaged about 3% per month, much lower than the early 2000's 4%, yet still quite high.

Job Turnover Rate. Source

In addition, real wages which had been falling ever since the 1970's, according to the Federal Reserve, show a clearly increasing trend since the mid-1990's, despite some ups and downs during the years.

Source: CPI and Wages

The unemployment rate has been decreasing since 2008 (although quite slowly) yet the most alarming issue is that the number of hours worked by the average American in the past years has been steadily increasing. While on average people were working 54.3 hours per week in 1979, in 2012 this has increased to 60.0. The trend seen in the next chart is more than obvious:

(Weekly compensation divided by Hourly compensation. Data can be found in the BLS website under codes LEU0208183700 and LEU0258178300 respectively.)

A most straightforward question which comes to mind is why do people feel like they need to increase their working hours if their real wages are increasing every year since 1996? The turning point in the graph was 2007. The reader will notice that between 1992 and 2007 working hours had fluctuated in the 56-57.4 interval without ever going past it. Yet, when the late-2007 crisis occurred, a jump in the graphs could be observed: between 2007 and 2009 people were working 1.5 hours more per week. In addition, labour productivity was also increasing in the 2007-2012 period which means that it wasn't that Americans were producing less than other periods in their history so they had to work longer to make up for it. Then, was this trend due to high turnover or high unemployment? Was it due to increased worry about what the future would bring or a willingness to save for debt repayment? My opinion is all of the above. It's not that easy to see everything around you shutter and not be willing to work some more in order to secure your job.

Source:BLS

This, however, comes at a cost. The more people are afraid, the more they are willing to postpone spending for the future, thus making the situation even worse. It is a sort of citizen-imposed austerity, with the same results as the state-imposed one. People work more, spend less, and watching unemployment rise and others around the world (e.g. Europe) facing difficulties makes them willing to live on a shoestring. As people get more and more afraid they fell victims to their employers' whims and requests as they are "willingly forced" to work longer hours out of uncertainty about their job stability and their future employment prospects; this uncertainty manifests as fear and spreads like wildfire through the economy.

Although the increasing trend in the number of hours worked is worrying there are remedies which can assist in making things better. Many still believe that even if people are finally persuaded to spend more, demand will never reach the heights of the pre-2008 era. I would respectfully disagree with them: data are not supportive of their claims and opportunities are still plenty. Unfortunately, they are still plenty because not all is good in the US.

Real personal consumption is increasing ever since the 1940's, despite the sharp drop during the recession. Yet, as commentators indicate, the crisis has taken its toll on the people: real household income had decreased by 4% in 2011 (data for 2012 are not yet available) and the poverty rate reached 15% or 46.5 million people in the same year, up from 14.3 in 2009 and 13.2% in 2008. Thus, there is plenty which can be done to boost demand, with most of it includes some sort of government intervention; either direct or indirect. Underprivileged members of the society could be given better education (in a country where some universities have endowments of over $1 billion, only 27% of the population has a bachelor degree) and more importantly a better chance to work somewhere that offers them the opportunity for personal and professional growth.

Many a policy (e.g. tax breaks for corporations hiring them, subsidies, scholarships, etc) could be implemented in order for the underprivileged to overcome their financial difficulties, yet these are beyond the scope of this article. What matters is that if income is increased by just $1000 a year on average then an additional $46.5 billion would be available for spending. This might not seem like much compared to the $9.5 trillion of total spending per year, yet the effect of these would be further increased over time with the increase in bank credit and accumulated jobs which would further stimulate the economy. In contrast to austerity's vicious cycle we would experience a virtuous cycle which would reduce the poverty level, increase real wages, decrease the total hours of work and in addition create more jobs and boost consumption, thus making the economy grow.

Those who fear that aggregate demand will fall in the future may be proven right if nothing is done to prevent such a turning of the events and the US will be one of the first countries to witness a permanent abundance of supply over demand, resulting in worsening economic circumstances. Regardless of whether we call it Keynesianism or Monetarism (which are in essence the same) the truth is that markest appreciate assistance in times of crises. I am not arguing that they would never get out of the crisis on their own, yet why should we force ourselves through the torment of a long-lasting depression when we know the doctrine which would help us overcoming the problems?

A (Small) Treatise on Inflation

Imagine, dear reader, that you are managing a company dealing in some trade. What you basically do is buy a good one day and then sell it a few days or weeks later. If one asked you the reasons for doing this, the answer would be obvious: profit, of course. Any firm wishing to stay afloat should sell higher than it buys, or at least intend to do so. Now, imagine if someone told you that we would have deflation in the economy, meaning that if you buy the good at €10 you would have to sell it at €9 or less because money would be scarcer and each unit of money would be worth more. Would you be willing to put your business and yourself through the trouble of buying and selling, if, at the end of the day you would end up with a loss? Doubtful.*

The situation presented above is the main reason why inflation is useful: it presents the opportunity for investment and growth because the incentive for profit-making exists. Deflation, on the other hand provides a disincentive for investment. This is not to say that all inflation is good. At times, an increase in the level of prices can prove disastrous for the economy, as for example in the cases of hyperinflation or stagflation. What follows is an attempt to explain what causes inflation and how at times of distress, having the notion that inflation will prevail assists in economic growth.

Milton Friedman became famous by promoting that "inflation is everywhere and always a monetary phenomenon". Although his aphorism may hold for hyperinflation up to a point (although hyperinflation and money supply are closed linked, hyperinflation cannot occur without the initial circumstances of a productivity shock occurring) and, as some studies claim, in the long-run, the short- and medium-term inflation is not fully explained by just the increase or the stability of the money supply. First of all, we need to understand that in order for the level of prices to increase, we need to experience a surge in demand, specifically in aggregate demand. The rationale behind this idea is that if we only witness an increase in the demand for good A while the one for good B is decreased then, when the basket of goods is calculated, they may cancel each other out and we will thus witness no alteration in the level of prices.

What an increase in the supply of money does is essentially make people richer in nominal terms. Thus, if people are richer they should spend more, at least according to theory; this will in its turn increase demand and make prices rise. The same would occur when additional credit is created via the banking sector. Both these actions make people richer, again in nominal terms, which means that they will spend more and thus we can experience an increase in the price level. 

The key word in the above paragraph is the word "spend". While in the long-run prices will more or less adjust themselves based on the money supply as the Quantity Theory of Money asserts (although this does not really hold) in the short run the consumer has to spend that money in order for the change in the level of prices to occur. If the money remains sealed in the banks and is not used for any productive means then no change in demand will occur. 

In economics, supply and demand are the factors which mostly affect the (temporary) equilibrium thus we should first focus on factors which shift demand, the first of which is consumption. Consumption is based on income, which in its turn is based on money and credit (and aggregate demand in itself). Most importantly, in the short run, consumption depends on the rate of time preference which dictates the propensity to save, subsequently affecting the velocity and quantity of money in the economy. We have seen how money and credit affect consumption (and effectively demand) in the previous paragraph; what remains is explaining how the propensity to save does it. Again it is relatively simple: if you save more, you consume less, thus aggregate demand falls and prices fall as well (if more money is saved than before, then both the velocity and the quantity of money circulating is decreased). Even if your income is higher than before or if you have access to more money (e.g. helicopter drops) or more credit than before, it does not really matter if you spend less than you did. Current prices are not formed by the potential for spending but from actual spending (although the argument that prices also reflect future expectations of inflation can be made, I seriously doubt this. Only current investment is based on expectations). What affects the rate of savings is peoples' perception of the future and their understanding of the current situation; this leads to higher savings rates during distress periods because uncertainty both about the present and the future is higher (for details on the subject read this).**

Another of the issues which affects consumption is obviously income. Income is nevertheless linked to consumption and inflation. When experiencing inflation, workers see their employers receive higher profits and thus have the incentive to bargain for higher wages. This in its turn increases consumption and demand, which re-enforces the inflationary cycle of wages and prices. Thus, when the propensity to save is increased, it opposite can be observed, i.e. both aggregate demand and prices fall. In addition, this means that profits for the employer will fall and that the employer will be forced to let some employees go in order to survive.

This brings to the surface another factor which affects inflation, albeit indirectly: the unemployment rate. When unemployment is high, demand is lower than before (since on aggregate people have less income than before) which means that prices should fall. Conversely, a decrease in the rate of unemployment indicates that people will have more money to spend (since aggregate income will rise), thus demand will rise and prices will rise in response.

Moving from the causes which affect demand, we take a look at the forces which account for aggregate supply. This can affect the level of prices in two distinct ways: either by increased supply costs or by a shortage in supply, both of which increase the level of prices. A shortage in supply is much more difficult to occur in times of distress than in times of boom, unless the good in question is a natural resource and we witnessing its depletion. Thus, when demand is on the rise, it will be more difficult for supply to keep up with it thus making prices rise (this, of course, depends on how fast demand in growing and how fast the economy can adapt to growing demand).

The next question would then be what affects supply costs. The answer is again is quite simple if we consider the costs a firm has to face: wages, raw materials, rent, new equipment. Consequently, a rise in any of these might cause the level of prices to increase (with the possible exception of new equipment which is most likely been accounted for in the pricing equation). Economists might argue that a change in the price of a good/service might affect its demand. This is true although up to a point. If a firm sells approximately 2 million goods per year and faces increased costs of €200,000, it may have to either increase its price by €0.10 to meet its targets or lay off some employees or reduce their salaries. Although the first option may (in theory) appear to be of unsure result due to price elasticities, in real life, the change in demand as a response to the price of a good depends on the existing price. For example, demand for automobiles will not really change if a new one costs €5001 instead of €5000. Conversely, if the price of a pencil is increased to €0.20 from €0.10 people might choose to buy something else, although it may again not matter as much as we think it does. (Yes I do understand elasticities. Yet, calculating elasticities is not as easy as it appears in real life; in fact, it is nothing more than a mere estimation)

Returning to the discussion of supply costs, an increase in wages, as we have already seen before, leads to an increase in the level of prices, both because of increased consumption as well as increased costs (this is sometimes called the wage spiral). To sum up supply costs, increases in the prices of raw materials, cause the price of the produced goods to increase. These may include both internationally set prices (e.g. oil or gold) or they may include goods whose is price is determined  by their sellers and buyers. Nevertheless, the increase in the price of raw materials, as well as the increase in finished goods can also be attributed to something which has been largely ignored by the academic society: a deliberate increase in the profit margin.

For example, a firm may choose to mark-up its products at a costs+30% margin. This would mean that if a product costs €10, the firm will sell it for €13. Suppose now, that the firm can change its profit margin by a small amount and this will have no important change in the demand for the good. For example, if the firm decides to sell the good for €13.5, thus earning a margin of 35%, it is quite doubtful whether the fall in demand would cancel out the increased profits. Thus, it is to the firm's best interests to raise the price, even if it means sacrificing some customers. Although some might argue that prices are at equilibrium and the firm will choose to increase prices only if demand is increased, this may occur also in the case where demand is lower. The supplier may assume that since demand is low, the price of the good for sale can be increased, since this will not alter demand by much (and may be, on occasion, be correct). Thus, increasing the margin will mean that the level of prices will be increased as it will cost more to buy the good now.

What should be noted is that if this happens in the first link of a supply chain, it is then almost impossible to realize what caused the increase. For example, as demand increases oil prices, it is more than rational to assume that the production prices in the economy will be increased as well, causing an increase in the level of prices. Yet, for goods which are not publicly traded like oil, it is much more difficult to distinguish the cause of the increase. For example, an increase in the price of a specific beer brand might be due to bad weather and increased wheat and barley prices, higher wages, higher transportation costs, higher electricity costs or just because the retailer or the wholesaler or the producer wishes to charge more.

It is infeasible to distinguish what causes prices to increase and by what extent, yet the reduction in prices can be focused just on lower demand or a deliberate shortage of money in the economy. As the latter is not a case which has taken place anywhere, and is doubtful that it will ever appear, focus should be shifted to the first case. Regressing to the example in the first paragraph, it makes it easier to see why businessmen wish for inflation when it comes to investing their money in a business. Inflation means that demand for goods will be higher in the future, which makes potential profits visible. Thus, this gives them an incentive to invest and, in their turn, boost the rise in demand by decreasing unemployment.

What has been described in the previous paragraph is nothing more than what is called inflation expectations. If investors believe that demand will rise in the economy, then it makes sense for them to invest in something which will yield them some profit from this increase. Elaborating on the point made above, when expectations of inflation are high, people wish to use the money they have saved in the economy to invest in goods. Nevertheless, the fact that expectations are high before the actual observation helps to smooth its movement by spreading inflation evenly throughout the period and not by having spikes every time inflation is announced. Thus, as expectations rise, investment also rises (which is what makes credible QE attempts successful in the longer run as shown here). In addition, what is also increased is consumption and inflation in the future. When investment is higher, it means that unemployment will fall and income will rise. This, as we have seen before, means that the level of prices will rise in the periods to come. Thus, although inflation is not currently increased by expectations, future inflation is.

Summing up, what affects the level of prices is basically everything which  affects aggregate supply and aggregate demand in the economy. What has not been mentioned yet is something which affects demand for goods directly, but is an issue which will trouble us more in the future: population. This issue had not traditionally received great attention by economists because this was something no-one could envision 50 or 100 years ago. In fact, the opposite was considered a problem, as Malthus had argued. This appears to no longer be the issue. Nevertheless, as population appears to be reducing, the interesting question of what will happen once less people are here to consume arises.

If, in any given period, we expect to have lower population than before, it means that we either have to face permanent deflation, if total money and income are the same, or a permanently increased level of money and public spending. The most known alternative for this, migration, will be to be infeasible in the case of world population decline. Just like Japan's recent experience has pointed out, in the case of a prolonged recession, it is much easier for fertility rates to fall. This will in its turn make aggregate demand fall even further, which would create further distress thus creating a vicious circle. Economic distress and signs of decay lead a country to population decline; while economic prosperity may also lead it down the same path (growth in income usually makes people have less children than before). The solution would be simple: incentives for people who have children could greatly benefit the economy as a whole. This would also increase demand and perspectives as with more people to consume in the future inflation would undoubtedly be on the rise.

Concluding, although inflation is not an issue clearly explained by economists, it is nothing more than a case of supply and demand. If we can manage to distinguish the factors which affect them, no matter how difficult it may be, then it will be easy enough to distinguish between what affects inflation and what does not. Furthermore, we have to understand that inflation is not the peril we have grown up to believe. Without inflation, no rational investor or businessman would bother to invest, and economic growth as we understand it would simply be brought to a halt.

*First of all, this is an accounting loss as accounting does not take into consideration the real value of money. Nevertheless, this could potentially be an economic loss as well since the real rate money does not necessarily need to be greater than 0 even in a deflation. In addition, precise ex ante knowledge of what the real rate will be is impossible.

** Readers may question whether interest rates affect inflation. Theoretically, they should affect it as higher rates create more incentive for savings. Nevertheless, it is not that rates are high or low to induce people to save or invest. They fluctuate because the business cycle fluctuates and not because of manipulation. Thus, interest rates are low when the propensity to save is higher (i.e. when demand for saving is high) and high when the propensity to save is lower (i.e. when demand for saving is low).

The need for austerity and growth

If one had been reading my articles regularly it might appear that I have not been a proponent of austerity measures. However, this is not the case. I do believe that austerity measures should take place in the countries that need it (e.g. most South European countries are in desperate need for a rationalization of their policies) BUT they should be manifested over the realm of several years, so as not to have dire consequences in the countries' economies.

The ECB officials (and their German counterparts at the Bundesbank) state that the reasoning behind hard measures is that they will not help a country which is not prepared to sacrifice a lot in order to be helped. This may be a valid reason but, with severe austerity measures employed, the countries are no longer competitive, as they face a strange situation with a demand which keeps going lower and lower while producer prices are rising. Recent statistical data from the ECB indicate this phenomenon in several countries. For example, while Greece has been struggling with austerity measures in the last year and a half, industrial producer prices in the domestic market have never stopped rising. The same holds for Spain, Italy and Cyprus. The latter is on the top of the EU list with a 9.1% rise in industrial producer prices since May 2011. Thus, while demand is shrinking, prices refuse to fall.

In the supply&demand world of economists it is obvious that prices will have to fall in order for demand to rise. Simple? Not very much. You see, this does take some time. When, for example the euro was introduced in 2002 the prices in local currencies had centuries of supply&demand experiences and thus at they were considered to be in equilibrium in most times (with the possible exception of recessions). However, after the introduction of the euro things changed. An increase in the level of prices occurred, in both goods and services, which was a result of rounding up. Extreme examples of rounding up (but yet not very rare) were for example rounding a good to a 4 euro price instead of a 3.5 one which was the normal conversion price.

A paper published by the ECB in 2009 indicates such price behavior as perceived inflation. Quoting (page 137)"However, there is a measurable break in this relationship at the time of the introduction of the euro. In all EMU member countries, perceived inflation dramatically jumps upwards, implying a shift in levels in the distance between inflation perceptions and HICP (Harmonized Index of Consumer Prices) inflation rates. While a temporary gap between actual and perceived inflation is not unusual (for instance, similar changes in the distance between both inflation measures can be observed for the United Kingdom in 2000), the magnitude and persistence of the increase in perceived inflation are remarkable." Then in page 138: "A more notable result is that the persistence of inflation perceptions has increased dramatically in almost all countries after 2002.Furthermore, there is evidence that in some countries the influence of expectations on perceptions has increased. That is, inflation perceptions by consumers appear to be increasingly affected by their own inflation expectations, while putting less weight on official price statistics."

I do apologize if I am boring you with technicalities, however this just indicates that prices have yet to be stabilized in the Eurozone, as a result of the Euro changeover. (a more technical paper can be found here) Hence, a crisis like the one we are now experiencing combined with the austerity measures undertaken by many countries will help stabilizing prices, most likely to a lower level. Nevertheless, such a procedure should be slow and last several years and not be rushed by taking measures which will worsen a country's competitiveness.(Well, it will anyhow since prices adjust slowly, but the procedure will be unnecessary difficult for citizen if it is faster than normal)

P.S. Latest news say that the ECB plans to buy Spanish and Italian bonds jointly with the ESM. Draghi says that the ECB will do all it can to save the euro. Hmm that would be the 50th time I have heard something similar! The difference between action and theory is the difference between masturbation and sex guys.