Real Life Effects of Deflation

Deflation is defined as the decrease in the level of prices:

As economic theory dictates, the causes are a fall in the money supply, in addition to (in the short-run) a fall in wages and salaries.

Compensation of Employees (aggregate) Source: ECB

Just like any other economic happening, there are those who claim that any type of deflation is disastrous and should be avoided at all cost while others believe that it is wonderful (since it lowers prices) and we should embrace it. As usual though, they are both wrong. The answer, simply put, is that it depends on the severity, duration and the overall state of the economy at the time when deflation is manifested. What follows are three points on the effects of the current rates of deflation on the real economy of the Eurozone.

1. As long as deflation is not severe and not persistent then the effects on consumption are small.
There is no person who would be willing to forgo a month's consumption of food just because it would get cheaper next month. Parents do not tell their children "you will not attend university now because it will be 2% cheaper next year". We have some basic needs which we will continue to satisfy as long as the deflation rate is not so severe so that an apple will be worth 50% less tomorrow than it does today. Prices fluctuate every day and a deviation of 1-2% per annum for a short period of time (e.g. 1-2 years until an economy gets back on track) does not really change our incentives for non-durable consumption.

Nevertheless, there is an effect on what we call durable goods (e.g. houses, automobiles, etc) but these are just a fraction of what we purchase (approximately 1/3 of our purchases are of durable goods). Even though 1/3 may appear to be large, remember that the reduction in price is more severe in some sectors than in others; automobile prices have not dropped by much (if any) while real estate prices have sunk compared to 2006. In addition, when a person has lower income than before, the first thing he stops purchasing is durable goods, not everything else. Thus, the drop in durable goods consumption can be seen as a natural reaction to the overall drop in confidence, investment and subsequently wages. Still, if deflation persists and becomes even higher in 2014-2015, a large drop in the consumption of durable goods might signify a reduction in investment, resulting in more wage losses and thus creating a vicious cycle.

2. Deflation has a stronger effect when households and non-financial corporations are heavily indebted.
The reason is simple: given that aggregate wages have dropped, prices also drop, triggering another round of wage drop and so on. Although this is an issue for durable consumption as discussed above, it is also a problem when it comes to debt as it takes more money in real terms to repay the amount owed. Thus, if in a country most of its citizens are over-indebted (see all periphery countries) deflation is bad because it makes repaying that debt even harder. Not only that, but it also creates a "death spiral": the more people try to repay their loans, the less they consume and thus prices and wages fall even further making the real amount they owe even higher. This is exactly what happened with austerity policies: less spending means less consumption thus less income for the state, leading to higher deficits and debt and forcing new austerity measures once again.

3. Deflation equals lower prices but it does not mean it's good for us.
This is one of the most common fallacies ever: if prices fall then it is great. It is most of the times but it always depends on the reason prices fall. If they do because raw material are cheaper or because of a productivity rise then great. But if they happen because people have less money than before then your purchasing power is most likely hurt in the short run (prices usually do not respond fast to shifts in consumption, even if those are permanent). In addition, if we shift from inflation expectations to deflation expectations then what we will see is less and less consumption, leading to lower wages and then lower production. This is the time when deflation gets serious as, with higher rates, we can actually see the economy reach a halt.

What should be noted is that the severity of deflation has a direct effect on the magnitude of the above. If deflation is at a very moderate rate of 1% per annum for a year or so, then most likely its effects on consumption and loan repayment will be very small; more or less of the same extent of what happens in the economy during every other recession. Only if deflation persists, becomes larger and is embedded in expectations will we need to seriously start about the future of the economy.

In order not to come to the worrying part though, policy (here's looking at you ECB) should be re-addressed so that confidence in the region is re-instated. Otherwise, we will soon see if markets can adjust fast enough not to cause any major casualties.

Life Expectancy and the Stock Market

Cross-posted from Pieria

Suppose, dear reader, that you are about to purchase a company. You examine its cash flows and annual profits, and estimate that these are on average $10 million a year. How much would you be willing to offer for such a purchase? Standard asset pricing models usually incorporate dividend or earnings along with a discount factor and the forecasted growth of earnings. Yet these are rather heavy assumptions: we cannot really estimate either the discount factor or the growth in earnings in the future. Thus, in practice, what other firms usually do (after confirming that the purchase is beneficial for them) is offer a price which is close to the stated share price at the given time of the purchase. 

Now, returning to our example how much would you be willing to offer a firm which earns $10 million a year if you are in your 20's? Probably you would suggest something like $120-150 million. How about in your 60's? The answer will most likely be something much less than the previous one, wouldn't it? This is what is usually called the investment horizon: when I have a longer horizon I can be almost certain that I will cover my costs in the future, which may not be the case if I have a shorter horizon.

Think about people who have very long horizons. Who might they be? Most likely, those who are quite young at the moment and have a lot of planning for their old age to do. If average life expectancy is 79 years of age as I write these lines, a 30-year-old will be sure to cover the amount paid in our example above in 12-15 years and have the rest to enjoy his profits. Yet, is one 30-year-old the same as another? Of course not: people have different risk profiles, different strategies and different amounts of wealth. Yet, let me put it another way: was a 30-year-old in 1900 facing the same horizon as one in 2010?

The answer, as you may have guessed, is no. In 1900 the average person was expected to live for 47.3 years, so he was less willing to part with his money now for a gain in the future. In economic terms his rate of time preference was much higher for the present than for the future, i.e. his β was very close to zero. So the discount factor, which is related to the time preference (though not the same), would force the company's valuation to be lower than it is now. Certainty of longer life spans makes our time preference for the present lower, which means that we are more likely to postpone consumption now on the promise of more consumption in the future. This can be easily seen in the data:

The graph indicates the P/E earnings ratio for the S&P 500 index with outliers (defined as anything greater than the average plus or minus 2 standard deviations) removed, while the straight black line is a simple linear trend line. Although P/E ratios fluctuate over time, the overall trend is positive. For example, in the first decade of the 20th century the average P/E ratio was 13.8; in the first decade of the 21st century it averaged at 29.5. At the same time, the average life expectancy was 49.5 years compared to 77.5 in the 2000's. The trend in life expectancy in the US can be seen more clearly in the following graph:

The graph points out that even under rare events (such as WWI in 1915-1918) there is an upwards trend since life expectancy is not affected by business cycles, expectations or any other economic factors. Thus, even though there is some slight variation at times when there have been wars and/or other catastrophes, the overall trend is much stronger than the one for the P/E ratio. Still, it appears that the longer the expected life of a person, the lower his or her aversion to the future, even though the former has to increase by much more for the latter to do so.

A simple example would be the P/E ratios in a boom: before the 1990's, the highest multiple in the 20th century was approximately 24 in 1934. In 2009, after the 2007 sub-prime lending crisis it reached a high of 70.89. , At the time of writing it is trading at 19.5, a value exceeded just 18 times since 1900, 15 of which were in the last 20 years.

The point here is that the longer we live, the lower our appreciation of the present will become, and the greater our need to save for the future. As our horizon extends, our time preference for the present decreases, leading to lower discount rates and higher prices. Thus, as people will live longer in the future, equity values will appreciate (as already discussed here). As our investments and investment vehicles become more focused in the long-run, just as pension funds are doing at the moment, the upwards trend for equity will continue with or without assistance (by which I mean QE ).

As already mentioned, even with declining populations, equity prices will continue to rise, creating a short-term inflation effect; interestingly, this effect can also be passed on to property prices (and the associated bank loans). The short-term future will be even more interesting: population will increase until the mid-21st century and we can safely assume that life expectancy will increase for even longer, with equity prices following. The change in the latter will of course be much smaller than the change in the former but the direction will be the same. As with any other variable, the trend will be far from linear as prices will fluctuate; but the long-term course will continue to be positive as long as life expectancy continues to increase.

The 1920's all over again: The Greek Transfer Problem

Germany in the 1920's: The Transfer Problem
Keynes, in 1929, stated that the problem of German reparations after World War I could be reduced into two issues: the Budgetary Problem (i.e. how to extract the necessary amount from the country) and the Transfer Problem (i.e. converting the German money received into foreign currency). The fact that Germany had been borrowing abroad for domestic capital purposes temporarily solved the problem, yet the situation could not hold for ever. Thus, the only potential resolution of finding the funds to cover for the Budgetary Problem would be to increase exports by a significant amount; a feat that could only be achieved by shifting factors of production from other employments to the German export industry.

The only reasonable explanation for Keynes was that Germany had to reduce her costs of production first, as supply of labour was more than enough at the time. Using this rationale, solving the Transfer problem would mean that German gold-costs of production relative to such costs elsewhere would have to be reduced either through increased efficiency, lowering of interest rates or lowering efficiency wages. As the first two did not appear to be available for change (efficiency was high at the time and lowering interest rates, i.e. cheap money for Germany, was not an option) a reduction of the efficiency-wages in Germany was the only alternative left.

However, such a reduction in efficiency wages would make the extraction of the funds needed for reparations (i.e. the Budgetary Problem) much more challenging. In addition, lowering money-wages would be to no avail if:
i.   Output could not be exported
ii.  Demand elasticity for Germany’s goods was less than one
iii. Germany’s competitors reduced their efficiency wages pari passu
iv.  Foreign customers imposed tariffs on German goods

This lowering of money-wages would not mean that real-wages would be reduced by the same amount as home-goods prices are expected to fall. On the other hand, efficiency could also be reduced in response to the wages which could trigger an even larger decrease in money-wages and so on.

The mechanisms which would provide for such a decrease in wages were two: the fall of the German Mark’s exchange rate (which was prohibited by the Dawes scheme) or by allowing the Reichsbank to enforce deflation, which would curtail the activity of business and throw people out of employment, so that when sufficient amount of workers are out of employment they would accept a reduction in their money wages. In Keynes's own words "Whether this is politically and humanly feasible is another matter".

Greece in the 2010's
On May 2nd, 2010, the IMF and the Eurozone authorities (Troika) agreed on a bail-out loan of €110 billion. The influx of funds, which was mainly employed in bank recapitalizations and debt restructuring, came with the need to increase government revenue, while simultaneously reducing expenses so that future installments could be met. Given that Greece did not possess a national currency to devaluate (much like Germany in the 1920’s) the additional three options had to be assessed; greater efficiency, cheaper money or lowering the money-wages.

Blue line: Corporate Lending Rate. Orange line: Mortgage Lending Rate

Although interest rates decreased slightly, they remained a relatively high level compared with the rest of the Eurozone, perhaps indicative of the fact that Greece is still at risk. Issuance of sovereign bonds was not an option for the country since she had been out of the markets since April 2010, thus, no opportunity for cheap money was not available. Increased efficiency was an issue considered in the country, yet, due to over-crowding in the government sector, lay-offs were implemented, both as a measure to increase efficiency as well as a measure to decrease government spending. Thus, the only remaining alternative was a reduction in money-wages.

Reduced government spending meant reduced state stimulus in the economy; thus, the Budgetary problem had to be resolved as less available money would have to compensate for the same amount of state revenues (to meet debt repayments). The challenge was no less tempting than the one faced by Germany in the 1920’s and the necessity to create additional income to compensate for the increased installments which had to be paid in the following periods, drove the economy to the only other alternative: deflation.

Not possessing a national currency (much like Germany could not devaluate hers) meant that the nation would either be forced to borrow from abroad to repay her current installments (which was infeasible for Greece) or increase the trade balance in favour of exports. In Keynes's mind, this could only occur if money-wages were reduced; as we have seen before indicate that before, money-wages in Greece decreased, although they were much stickier than most expected.

The shift of factors of production in Greece the borrower’s price of Imports relative to Exports is consistently rising over time, which leads to decreased export prices and increased import ones. This is consistent with the Keynesian premise that factors of production need to shift from industries which focus on domestic goods to ones which focus on exports, consequently decreasing export prices as a result of lower efficiency wages.

Import over Export Prices

Conclusion
Since Greece was unable to devaluate her currency to accommodate for the flow of goods in her economy after the first bail-out, the transfer problem deteriorated the nation’s finances, which promoted a shift in the factors of production from home-goods to export-goods, albeit at a significant cost to the country’s economy: unemployment has exceeded 26%. Consequently, the Budgetary problem of extracting a significant amount of funds from a reduced amount of wages in an economy, arose; this in its turn provided the need for debt restructuring, both in the sense of reducing the debt burden as well as making debt terms more lax. 

Why should we pay attention to this? Simply because this has been largely ignored by most economists when the design of the Greek restructuring plan took place (and every other EU bail-out before or since, to be fair) and led to consequences econometric models were unable to project. In addition, since none of the countries which received a bail-out has been able to come out of it successfully yet, (although Cyprus has some hopes since new bank loan offers have already began) the matter presented here should be of extreme interest both for any future bail-outs that may be needed (Slovenia is likely candidate for example) as well as for re-examining where policy went wrong in the Eurozone. Past experiences with austerity when countries had their own sovereign currencies had nothing to do with what was (and is) asked of the bailed-out member: a depreciation of the exchange rate when there is no exchange rate to depreciate. This is what has mainly been the cause of the severe contraction of the Eurozone economy has been the inflexibility of the economy (see also here) which is a result of stickiness in the short-run and the lack of sovereign currency to depreciate. In its turn, this forced the shifting of factors of production from one sector to another while at the same time created an army of unemployed.

To paraphrase Keynes, it appears that such policies were deemed as politically and humanly feasible in the 2010's EU. Unfortunately, the costs were both miscalculated and neglected.

Housing Bubbles

The data below are from a Eurostat estimate of the Housing Price Index in all EU nations. 4 out the 6 EU countries in trouble (Spain, Ireland, Greece and Cyprus) can attribute all or part of their troubles to a housing bubble and the graph is indicative of this fact. Specifically, in the case of Ireland the rise and fall of housing prices is astonishing. The index which reached as high as 150 in 2007 is now looking to stabilize at about 75.

When beginning this article, I had in mind foreign purchases of housing units in each of the above nations. Foreign purchases, especially in relatively small countries like Greece, Ireland and Cyprus can significantly increase the level of prices, especially in a short period of time. I was only able to find some data for Spain which state that "Property sales made by foreign residents in Spain experienced an increase of 24.7% in the third quarter of 2011". In another article, 8.9% of purchases in Spain was attributed to foreigners. If in a country as large as Spain (with a 46 million population) foreign purchases of real estate can amount to that much you may imagine how much they could amount for in the aforementioned 3, which have a combined population of 16 million.

Compare this to Denmark, where the state law indicates that "Unless foreigners are permanent residents in Denmark and have lived in the country for a period of at least five consecutive years, Danish law states that they must obtain permission from the Danish Ministry of Justice (Justitsministeriet) to buy property. (unless they will use it as a permanent residence)" Even though the law is harsher on foreigners in Denmark than the rest of the Southern nations, we can easily question what it has done to prevent a housing boom in 2007 and 2008. Although the subsequent fall was not as sharp as the one experienced in Ireland, it was approximately like the one in Cyprus, and much worse than the one in Greece and Spain.

Then what is the solution for not experiencing housing bubbles you may ask? The answer is relatively simple: increased taxes in real estate combined with stricter mortgage regulations. Although Denmark's law did not stop the country from experiencing a rapid fall in housing prices, we cannot know what would have happened without it. However, when real estate taxation is high (and I do mean tax paid on the unit's value not transfer costs, lawyer fees and other costs relating to the purchase) less people would be willing to buy a house if they do not intend to live in it. Nevertheless, taxation should be lower for those who are buying their first house, with the purpose of living in it. As young couples are what is driving demand in most nations, with the application of such laws the governments would have taken specific measures to safeguard this demand. 

Also, when mortgage demands are stricter (forcing you to have at least 20-25% of the value of the unit you intend to purchase) demand will be more stable and the banks will face less problematic loans. With demand not rising and falling to extremes, it would be much easier for developers and real estate agents to predict the market's future needs and thus they themselves would be less inclined to fund projects which would take many years to yield profits, straining the banks and the economy. 

Nobody in their right mind could ever propose that bubbles can be left out of the system. Demand will always fluctuate and we can do our best to estimate it. Most likely our estimation will be wrong; and we can surely not expect strange phenomena like hurricane Sandy which caused some USD 71 billion of damages in the states which it hit. Nevertheless, it would also be a shame not to do what is expected of us to make this world less crisis-prone.

Property Market: Cheap or not so Cheap?

A direct consequence of the EU crisis is that housing prices in South Europe have began to fall. For example take a look at the graph for Greece:

The downwards trend which started in late 2008 still holds strong pushing residential housing prices down. The same holds for Spain and Cyprus (Unfortunately I couldn't find data up to 2012 for Italy. All data and graphs are from the ECB)

Cyprus residential prices

Spain residential prices

The above and all current developments indicate that the severe inflation of housing prices which had occurred during the early and mid-2000's was something of a bubble. Mind you, these are data just for the first quarter of 2012. You may only imagine how lower the prices of the second quarter will be.

The housing bubble seems about to burst in the EU (it already has in some countries) and it's not just prices in the South that have gone down. UK prices have fallen for the first time in 3 months as Britain's economy shrank by 0.7% in the second quarter of 2012, the most in 3 years. (for more details on the UK's housing market read here)

If one looks at ECB it seems that housing prices all over the EU are either stagnant or falling, with a few exceptions. So, many people are faced with a dilemma? Should you buy or should you keep on renting? The answer is not so obvious. The reason is that during a crisis rents are higher while housing prices are lower, since most people cannot afford to buy (fall in demand, thus prices fall) but they have to live somewhere (rise in demand, thus prices rise). In more distressed economies like the South, many still choose to live with their parents and thus both rent and property prices seem to fall, although the latter seem to take the most hits.

True, prices have fallen dearly since last year. This, however, is only the beginning of the downwards spiral which will run its course for at least the full 2013 in strong economies and last even more in the weaker ones. (I hope you can tell which is which!) Moments of a rise in the indexes may occur but these seem more like an slight upwards move right before a severe downwards movement in the stock market.

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.