With the crisis over Greece’s debt defused for now, ECB president Mario Draghi can return to the main challenge of his tenure: preventing a deflationary spiral in the European economy.
By Vikram Rangala
Wednesday, February 25, 2015
Europe, like the US, needs more inflation. The euro currency, which fell sharply in 2014, continues to struggle near record lows versus the US dollar and is likely to stay low for a while.
While this is great news for dollar-spending tourists in Europe, it’s a challenge for everyone else. Contrary to what you might assume, a healthy economy needs a certain level of inflation. At first that doesn’t seem logical: after all, who wants higher prices? You have to see the whole picture.
Gasoline, for example, is cheaper and it’s easy to see when you fill up the tank. Harder to see is the difference in shipping costs, or the cost of plastics and other things made from petroleum. Consumers often don’t realize that those things are getting cheaper as well and in some cases, hurting the profit margins of shippers and refiners.
The Hidden Costs of Low Prices
Some effects of low inflation are so hidden even economists sometimes miss them. For example, when prices don’t go up, salaries and hourly pay don’t go up much, either. Companies can’t afford to pay employees more if they aren’t making money.
When inflation is moderate (above the 2% target the Fed has set), then companies can use some of that increased income to give their employees raises and still keep enough to show increased profits. Economists call it “money illusion.” It’s a standard trick, to raise pay but not raise it enough to keep up with inflation. Ethics aside, companies find that employees don’t usually complain because, hey, they’re getting raises. When inflation is lower, companies have to resort to wage cuts or layoffs.
Right now in the US, employment is growing, but wages are not growing as much. In fact, many unemployed people are returning to the workforce in jobs that pay less than their old jobs. Fed Chair Yellen cited stagnant wage growth as a major reason why she is in no hurry to raise interest rates.
In Europe, the situation is worse, in part because Europe is just starting its quantitative easing program, where the US has already finished. In Europe, both job growth and wage growth are zero or even negative in some countries. Companies don’t even have the money to give out “money illusion” raises. They have to cut pay or lay people off. Draghi needs prices to increase so businesses have more money to pay people. The 25% unemployment rates of the recent past create civil unrest and political turmoil.
There are other reasons why deflation is dangerous. For example, when prices are falling, consumers will delay purchases in the hope of getting cheaper prices later on. It’s hard to run an economy when no one wants to buy anything. The negative interest rates that some European countries are effectively instituting would actually charge people for keeping their money in the bank. It’s supposed to be an incentive to get them to spend, but more likely people will just put their money in the proverbial mattress.
The Relationship of Deflation, Wage Stagnation, and Debt
The relationship of interest rates to inflation and wages works on several levels, but the personal level may be the easiest to understand. If you have debt, like a student loan or mortgage, you have monthly payments, which you probably pay out of your monthly paycheck. If your wages are cut, your debt amount remains the same and quite likely your monthly payment won’t change, either. Remember what a big deal it was when Pres. Obama reformed student loan repayments to make them a certain percentage of monthly income?
Now imagine that your wages are stagnant or even cut, but your debt payments have gone up because interest rates have gone up. Do you see that this can be devastating for families that are just getting by? This is why the Fed, and the ECB to an even greater degree, can’t raise interest rates until inflation goes up.
Until business are able to increase prices and thereby pay more and hire more and thereby make it easier for workers to spend and pay off debt without hardship, raising interest rates will only cause more bankruptcy and suffering. Sure, lenders would love to get a higher return, but they also realize that they get no return if their customers can’t pay them back.
Trade the EUR/USD Exchange Rate Using Binary Options
Nadex offers binary options on the EUR/USD, which give you the ability to trade these two currencies that are at different points along the quantitative easing, deflation fighting curve. You can participate in those currency markets with limited risk. It may help to keep in mind that behind those price ticks, the goal for both the Fed and ECB is to raise inflation just enough. And the real goal is good jobs for people.
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