The euro zone is heading for deflation

This is Daily Telegraph’s Ambrose Evans-Pritchard quoting me on the risk of deflation in the euro zone:

“Europe is heading into a deflationary scenario if they don’t do anything to boost the money supply,” said Lars Christensen… “This already looks very similar to what happened in Japan in 1996 and 1997.”

If you don’t already realise why I am talking about the risk of deflation then you just have to remember the equation of exchange – MV=PY.

We can rewrite the equation of exchange in growth rates and rearrange it. That gives us the the following model for medium-term inflation:

(1) m + v = p + y


(1)’ p = m + v – y

If we assume that money-velocity (v) drops by 2.5% y/y (the historical average) and trend real GDP growth is 2% (also more or less the historical average) and use 3% as the present rate of M3 growth then we get the follow ‘forecast’ for euro zone inflation:

(1)’ p = 3 % + -2.5% – 2% = -1.5%

So the message from the equation of exchange is clear – we are closer to 2% deflation than 2% inflation.

Yes, the world is much more complicated than this, but I believe this is a pretty good illustration of the deflationary risks in the euro zone.

We still don’t have outright deflation in the euro zone, but we are certainly getting closer – and inflation is certainly well below the ECB’s 2% inflation target. The graph below clearly shows that.

GDP deflator inflation euro zone

So effectively the ECB has been undershooting it’s 2% inflation target since 2008 – at least if we use the GDP deflator rather than ECB’s preferred measure of inflation (HICP). See my earlier post on why the GDP deflator is a much better indicator of monetary inflation than HICP here.

The reason for these deflationary tendencies is obvious – overly tight monetary policy.

Just have a look at this graph – it is the level M3 versus a hypothetical 6.5% growth path for M3. (If you read this blog post you will see why I use 6.5% as a benchmark)

M3 eurozone

This is why I talk about the need to “boost” money supply growth. The ECB either needs to increase velocity growth (the fed and the BoJ is likely helping a bit on that at the moment) or money supply growth otherwise the euro zone is heading for deflation. It is pretty simple.


Related posts:
Failed monetary policy – the one graph version
Failed monetary policy – (another) one graph version
Friedman’s Japanese lessons for the ECB

Leave a comment


    • JP, I am afraid you are right. There is a ‘fiscal obsession’. On the one hand the Germanic hawks want more fiscal austerity and on the other the leftist-populists wants more government spending. None of them are aware of the monetary causes of the crisis. It is very depressing.

      • Deflation can be caused also by a decrease in government, personal or investment spending. No?

  1. ep, no I don’t think that government spending, consumption or investment can cause deflation IF monetary policy is kept on track. Obviously if one of these factors causes a money-velocity (V) to drop and ECB does not counteract that by increasing M then these factors could add to deflationary pressures. However, as a general rule we have monetary dominance over fiscal policy.

    Said, in another way monetary policy can always “overrule” any impact on prices and nominal GDP from for example fiscal policy.

    Therefore, even if all EU governments cut public spending in half the ECB would be able to counteract the impact on this on prices by expanding the money base/supply. The problem obviously is that the ECB has not done enough to expand the money supply in the last 5 years.

  2. Very interesting posting.

    PS: Lars, I have some nice charts which might be of interest to you regarding the money multiplier in the euro zone
    and here

  3. As always, I did like your analysis on these monetary question Lars; however, wouldn’t it be better not to assume that money velocity is still declining? I agree that it does decline around 2 or 2.5% on average in normal times; but financial stability must have had an impact on the demand of money. Thus why I would suggest the use of a more modest decline in money velocity in the quantity equation or even a mild increase. Thank you for your very interesting posts. Best, Juan Castaneda (theoldlady …)

  4. Benjamin Cole

     /  March 13, 2013

    Ugly time.

    BTW, seven of the last nine monthly CPI readings in the USA have been flat to down.

    And you know the story in Japan.

    So, we have deflation in Japan, USA and Europe.

    And perma-zero-bound.

    Which means the only good buy is bonds, preferably government bonds, And that creates a huge class militant against any increases in interest rates…..

  5. Would like to know what you think about the inflation in Germany and Northern Europe?

    • Peter,

      First of all since Germany is in a monetary union the important thing is not inflation in Germany, but rather in the entire euro zone. That said, I don’t see any particular inflation risk in Northern Europe. Even though Germany is growing faster than most of the other euro zone countries Germany’s growth performance is still lackluster.

      In fact if you look at the GDP deflator German inflation has consistently been below 2% since 2002 and only average around 1% for the entire period. At the moment GDP deflator inflation in Germany is around 1.5%. So is anything monetary conditions are too tight (!) for Germany.

  6. Still Germany, Finland, Austria, Dutch have 40% of EZ GDP. Finland is at the forefront with 3.1% GDP deflator.

    As opposed to supply shocks, a steady increase of wages (like in Finland) have a long-lasting effect rather on the GDP deflator. This already translates in the shift for Germany from 1.0% to 1.5%.

    What about Australia? Last year GDP deflator 108, now 101.

    Why has Australia not cut rates to 2% or lower?

    Btw, why should you go for maximum of 2% for the GDP Deflator?

    • Effectively the Finnish economy has been hit hard last year, because margins and terms of trades are seriously weakening. Wages have risen too much, while demand broke from Russia and Europe.

      This is something Germany might repeat in some of the coming years.
      For Germany it is hence time to hike rates before the deflator hits 2%

  1. The euro zone is heading for deflation | Fifth Estate
  3. The damage done by ECB’s rate hikes in 2011 (the 3-graph version) | The Market Monetarist
  4. The depressing state of European monetary “thinking” | The Market Monetarist
  5. Lower (supply) inflation is NOT a reason to ease US monetary policy | The Market Monetarist
  6. Mr. Draghi you have not delivered price stability. Now please do! | The Market Monetarist

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