n contrast to inflation, where the general level of prices rises, encouraging consumption and investment, deflation discourages both, as savers hoard cash with the expectation that prices will fall, and their unwillingness to spend causes prices to do just that. The result is a downward spiral in activity, which, if severe enough, can lead to depression, as was seen throughout much of the world in the 1930s.

“The worry is if there’s a widespread decline in activity,” observes Kevin Logan, chief US economist for HSBC. “We’re on the edge of it.”

Some observers distinguish between “good” and “bad” deflation and point to the positive impact of falling oil prices as an example of the first, at least to the extent that the decline puts more money in the hands of consumers and encourages them to boost their spending. The US Federal Reserve has embraced that view, at least in its public pronouncements.

To the extent oil’s price decline is related to demand, it is mostly an effect rather than a cause of deflation.

“The transmission channels [for monetary stimulus] are broken,” says Mark Blyth, a professor of political economy at Brown University. “We’ve been trying to solve a fiscal problem with monetary instruments.” He contends that’s impossible to do with rates at the so-called “zero lower bound,” adding, “If you’re in the middle of a recession, why would anyone borrow?”

The challenge now, however, is to convince companies and consumers that the bank will be aggressive enough to reverse the direction of prices. That conviction is critical, because the actual stimulus provided by QE to the real economy will be more limited than it has been, for example, in the United States.

For one thing, European companies remain more dependent on banks for financing, so the health of the financial sector and its ability to lend is more important than if, like US companies, they relied on capital markets for finance. Yet many experts think eurozone banks remain too weak to do much lending.

“The problem with the eurozone is that there has been very little deleveraging, and it has not fixed its banks,” says Jan Dehn, director of research for Ashmore Research. In addition, ownership rates of homes and securities in the eurozone are much lower than they are in the United States or the United Kingdom, so there isn’t as much of a wealth effect to be gained from pushing up asset prices through bond purchases.


Which sectors of the economy are most threatened by deflation? The list is long, according to Kevin Logan, chief US economist for HSBC.

As he sees it, the first victims are consumers and companies in debt, as deflation increases its value while hurting their ability to service it. Retailers holding inventory also suffer, says Logan, as its value declines. Third, he says, industrial and commercial companies find themselves at risk, as producers of capital goods see their prices fall faster than wages.

That’s already been seen most clearly, he notes, in the oil sector and among suppliers to the industry, such as steel companies and capital goods makers. Caterpillar, for example, recently forecast that its revenues in 2015 would decline by 9% from last year’s because of the decline in oil prices. In addition, says Logan, producers of final products begin to suffer as their inventories become worth less.

Finally, deflation hits banks as they experience loan losses and can’t provide credit even to good borrowers. Logan notes that the same thing can happen in recessions. But with deflation, he says, the effect is “slower and more prolonged.” What can companies themselves do about deflation? Reducing prices may help them become more competitive and gain market share, but margins will suffer, as wages are slower to fall. And so the move ultimately eliminates profits.


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