Sam Vaknin
11 min readAug 26


The Merits of Inflation in Europe

By: Sam Vaknin, Brussels Morning

Headline inflation fell from 7% in April to an annually adjusted 6.1% in May, announced Eurostat. Retail prices will follow suit in a few months. Core inflation — a more relevant indicator — is down to 5.3%.

But is it necessarily a good thing? I argue that it is time to consider the twin risks of recession and deflation. The recent bout of inflation was not structural but conjectural: the outcome of a set of unprecedented circumstances (the pandemic followed by the war in Ukraine). As the former recedes and the latter stagnates, inflation will abate, willy-nilly.

The role of the ECB is confined to taming prices and ensuring monetary stability, without second guessing the markets, even when these are evidently in the throes of asset bubbles.

In the past few decades, this obsession with price stability led to policy excesses as disinflation gave way to deflation — arguably an economic ill far more pernicious than inflation.

Deflation coupled with negative savings and monstrous debt burdens can lead to prolonged periods of zero or negative growth.

Moreover, in the zealous crusade waged globally against fiscal and monetary expansion — the merits and benefits of inflation have often been overlooked.

As economists are wont to point out time and again, inflation is not the inevitable outcome of growth. It merely reflects the output gap between actual and potential GDP.

As long as the gap is negative — i.e., whilst the economy is drowning in spare capacity — inflation lies dormant. The gap widens if growth is anemic and below the economy’s potential. Thus, growth can actually be accompanied by deflation.

Indeed, it is arguable whether inflation had been ever subdued by the farsighted policies of central bankers. A better explanation might be overcapacity — both domestic and global — wrought by decades of inflation which distorted investment decisions. Excess capacity coupled with increasing competition, globalization, privatization, and deregulation led to ferocious price wars and to consistently declining prices.

Taming inflation can easily get out of hand.

A truer gauge of forward-looking price pressures is the implicit price deflator of the non-financial business sector. Using this indicator, inflationary shocks often give way to deflationary and recessionary aftershocks.

Depending on one’s point of view, this is a self-reinforcing virtuous — or vicious — cycle. Consumers learn to expect lower prices — i.e., inflationary expectations fall and, with them, inflation itself. The intervention of central banks only hastens the process. But benign structural disinflation can transmogrify into malignant deflation.

It is universally accepted that inflation leads to the misallocation of economic resources by distorting the price signal. Confronted with a general rise in prices, people get confused. They are not sure whether to attribute the surging prices to a real spurt in demand, to speculation, inflation, or what. They often make the wrong decisions.

They postpone investments, or over-invest, or embark on preemptive buying sprees. As Erica Groshen and Mark Schweitzer have demonstrated in an NBER working paper titled “Identifying inflation’s grease and sand effects in the labour market”, employers — unable to predict tomorrow’s wages — hire less.

Still, the late preeminent economist James Tobin went as far as calling inflation “the grease on the wheels of the economy”.

What rate of inflation is desirable? The answer is: it depends on whom you ask. The European Central Bank maintains an annual target of 2 percent. Other central banks — the Bank of England, for instance — proffer an “inflation band” of between 1.5 and 2.5 percent. The Fed has been known to tolerate inflation rates of 3–4 percent.

These disparities among essentially similar economies reflect pervasive disagreements over what is being quantified by the rate of inflation and when and how it should be managed.

The sin committed by most central banks is their lack of symmetry. They signal a visceral aversion to inflation — but ignore the risk of deflation altogether. As inflation subsides, disinflation seamlessly fades into deflation. People — accustomed to the deflationary bias of central banks — expect prices to continue to fall. They defer consumption. This leads to inextricable and all-pervasive recessions.

The Mismeasurement of Inflation

Inflation rates — as measured by price indices — fail to capture important economic realities.

As the Boskin commission revealed in 1996, some products are transformed by innovative technology even as their prices decline or remain stable. Such upheavals are not captured by the rigid categories of the questionnaires used by bureaus of statistics the world over to compile price data.

Cellular phones, for instance, were not part of the consumption basket underlying the CPI in America as late as 1998. The consumer price index in the USA may be overstated by one percentage point year in and year out, was the startling conclusion in the commission’s report.

Current inflation measures neglect to take into account whole classes of prices — for instance, tradable securities. Wages — the price of labor — are left out. The price of money — interest rates — is excluded. Even if these were to be included, the way inflation is defined and measured today, they would have been grossly misrepresented.

Consider a deflationary environment in which stagnant wages and zero interest rates can still have a — negative or positive — inflationary effect. In real terms, in deflation, both wages and interest rates increase relentlessly even when they stay put. Yet it is hard to incorporate this “downward stickiness” into present-day inflation measures.

The methodology of computing inflation obscures many of the “quantum effects” in the borderline between inflation and deflation. Thus, as pointed out by George Akerloff, William Dickens, and George Perry in “The Macroeconomics of Low Inflation” (Brookings Papers on Economic Activity, 1996), inflation allows employers to cut real wages.

Workers may agree to a 2 percent pay rise in an economy with 3 percent inflation. They are unlikely to accept a pay cut even when inflation is zero or less. This is called the “money illusion”. Admittedly, it is less pronounced when compensation is linked to performance.

Friction Inflation

As early as November 2000, economists in a conference organized by the ECB argued that a continent-wide inflation rate of 0–2 percent would increase structural unemployment in Europe’s arthritic labour markets by a staggering 2–4 percentage points.

Akerloff-Dickens-Perry concurred in the aforementioned paper. At zero inflation, unemployment in America would go up, in the long run, by 2.6 percentage points. This adverse effect can, of course, be offset by productivity gains, as has been the case in the USA throughout the 1990's.

The new consensus is that the price for a substantial decrease in unemployment need not be a sizable rise in inflation. The level of employment at which inflation does not accelerate — the non-accelerating inflation rate of unemployment or NAIRU — is susceptible to government policies.

Vanishingly low inflation — bordering on deflation — also results in a “liquidity trap”. The nominal interest rate cannot go below zero. But what matters are real — inflation adjusted — interest rates. If inflation is naught or less, the authorities are unable to stimulate the economy by reducing interest rates below the level of inflation. This has been the case in Japan and in the USA.

A central bank, having cut rates aggressively and unless it is willing to expand the money supply aggressively may be at the end of its monetary tether. An assertive monetary expansion is what Paul Krugman calls “a credible promise to be irresponsible”.

Inflation is exported through the domestic currency’s depreciation and the lower prices of export goods and services. Inflation thus indirectly enhances exports and helps close yawning gaps in the current account.

But the upshots of inflation are fiscal, not merely monetary. In countries devoid of inflation accounting, nominal gains are fully taxed — though they reflect the rise in the general price level rather than any growth in income. Even where inflation accounting is introduced, inflationary profits are taxed.

Thus, inflation increases the state’s revenues while eroding the real value of its debts, obligations, and expenditures denominated in local currency. Inflation acts as a tax and is fiscally corrective but without the recessionary and deflationary effects of a “real” tax.

The outcomes of inflation, ironically, resemble the economic recipe of the “Washington consensus” propagated by the likes of the rabidly anti-inflationary IMF. As a long term policy, inflation is unsustainable and would lead to cataclysmic effects. But, in the short run, as a “shock absorber” and “automatic stabilizer”, low inflation may be a valuable counter-cyclical instrument.

Inflation also improves the lot of corporate — and individual — borrowers by increasing their earnings and marginally eroding the value of their debts (and savings). It constitutes a disincentive to save and an incentive to borrow, to consume, and, alas, to speculate. “The Economist” called it “a splendid way to transfer wealth from savers to borrowers.”

The connection between inflation and asset bubbles is unclear. On the one hand, some of the greatest fizz in history occurred during periods of disinflation. One is reminded of the global boom in technology shares and real estate in the 1990's.

On the other hand, soaring inflation forces people to resort to hedges such as gold and realty, inflating their prices in the process. Inflation — coupled with low or negative interest rates — also tends to exacerbate perilous imbalances by encouraging excess borrowing, for instance.

Still, the absolute level of inflation may be less important than its volatility. Inflation targeting — the latest fad among central bankers — aims to curb inflationary expectations by implementing a consistent and credible anti-inflationary as well as anti-deflationary policy administered by a trusted and impartial institution, the central bank.

Deflation and the Value of Cash

Traditional economics claims that deflation actually increases the value of cash to its holder by enhancing its purchasing power in an environment of declining prices (negative growth in the average price level). Though highly intuitive, this is wrong.

It is true that in a deflationary cycle, consumers are likely to delay consumption in order to enjoy lower prices later. But this precisely is what makes most asset classes — including cash — precarious and unprofitable.

Deflationary expectations (let alone actual deflation) lead to liquidity traps and zero interest-rates. This means that cash balances and fixed-term deposits in banks yield no interest. But, even zero interest translates into a positive yield in conditions of deflation. Theoretically, this fact should be enough to drive most people to hold cash.

Yet, what economists tend to overlook is transaction costs: banks charge account fees that outweigh the benefits of possessing cash even when prices are decreasing. Only in extreme deflation is cash with zero interest a profitable proposition when we take transaction costs (bank fees and charges) into account. But extreme deflation usually results in the collapse of the banking system as deleveraging and defaults set in. Cash balances and deposits evaporate together with the financial institutions that offer them.

Moreover: deflation results in gross imbalances in the economy: delayed consumption and capital investment and an increasing debt burden (in real, deflation-adjusted terms) adversely affect manufacturing, services, and employment. Government finances worsen as unemployment rises and business bankruptcies soar. Sovereign debt — another form of highly-liquid, “safe” investment — is thus rendered more default-prone in times of deflation.

Like inflation, deflation is a breakdown in the consensus over prices and their signals. As these are embodied in the currency and in other forms of debt, a prudent investor would stay away from them during periods of economic uncertainty.

At the end, and contrary to the dicta of current economic orthodoxy, both deflation and inflation erode purchasing power. Thus, all asset classes suffer: equity, bonds, metals, currencies, even real-estate. The sole exception is agricultural land. Food is the preferred means of exchange in barter economies which are the tragic outcomes of the breakdown in the invisible hand of the market.

To tame inflationary pressures in the long run, Europe should focus on remedying structural issues: labor mobility, reskilling, banking reform and stability, intra-EU coordination of policy measures, and the like.

But, by far, the most pressing problem may be inequality. Leaving aside its ramifications in terms of social unrest, inequality creates perverse incentives and extreme misallocation of economic resources.

Income Inequality and Deflation

The core problem in Europe might ultimately be the rising income and wealth inequalities almost to American levels in some countries.

The more money we make, the less we appreciate its relative, respective, and proportional value to others. With very few exceptions, rich people, no matter how stingy, seem to lose touch with the pecuniary reality of the “99%” of the population who are poor(er). Indeed, to the wealthy, money is not a store of value as much as a token which allows them to participate in economic and non-economic games.

I call this process of desensitization to the value of money “personal inflation” because, precisely like “classic” inflation, as far as these affluent persons are concerned, it thwarts the price signal and distorts the efficient allocation of economic resources. It also misinforms their decisions and adversely affects their motivation to work, save, and invest.

Rich people have an “inflationary mindset”: they prefer to spend their capital, but owing to the amounts involved, are forced to hold on to the bulk of it, tied down in assets, both tangible and financial. They wish to consume (inflationary effect), but end up saving (deflationary outcome.)

Poorer folks have a deflationary state of mind: they would like to hold on to their money, but are forced to spend most of it, or even all of it (not to mention avail themselves of additional credits and loans.) They wish to save (deflationary effect), but end up consuming (inflationary outcome.)

Thus, all economic players in the marketplace wind up acting irrationally: against their innermost as well as expressed wishes and preferences. This gulf between the desires and actions of all economic agents is the main source of instability and uncertainty in the capitalist system, based as it is on wealth transfer from the many to the few and its accumulation in the hands of the latter.

What are the effects of these discrepancies in the perception of money between the rich and the rest of us? How is this psychological gap — indeed: this abyss — manifested in economic expectations and in one’s grasp of one’s purchasing power (based on streams of future income)? How does the price signal react to income inequality?

The larger the disparities between rich and poor, the greater the share of national wealth held by the rich, the more deflationary the economy. Rich people consume only a tiny portion of their wealth. The rest is tucked away in the vaults of financial institutions, in real-estate, or in art. Their money is effectively taken out of circulation and its velocity drops precipitously.

Admittedly, rich people’s savings do serve as a source for investments, but only when the transmission mechanisms of the financial system are intact and when trust is reasonably high. In times of crisis and recession, financial institutions tend to be rendered dysfunctional and trust abates. Redistribution via schemes of progressive taxation does ameliorate some of the deflationary effects of income inequality, but can never counter it wholly.

The political will to tackle this pernicious problem is not there, alas. The revolving door between politics (including regulatory agencies) and business is a major disincentive to any true reform.

The absence of political zeal to introduce change is everywhere. This is why Europe’s tax burdens and governments’s shares of GDP have been soaring inexorably with the consent of the citizenry, for example. People adore government spending precisely because it is inefficient and distorts the proper allocation of economic resources. The vast majority of people are rent-seekers.

Witness the mass demonstrations that erupt whenever governments try to slash expenditures, privatize, increase the pension age, reduce their debt burdens, and eliminate their gaping deficits. This is one reason the IMF with its austerity measures is universally unpopular.

The fight against inflation should never take center stage. It is an unwelcome distraction. Reforming Europe is the key. Inflation comes and goes. Europe’s economic deficiencies and deformities are here to stay unless they are confronted resolutely. Indeed, in the long-term, these are the very engines and causes of inflation.

Sam Vaknin, Ph.D. is a former economic advisor to governments (Nigeria, Sierra Leone, North Macedonia), served as the editor in chief of “Global Politician” and as a columnist in various print and international media including “Central Europe Review” and United Press International (UPI). He taught psychology and finance in various academic institutions in several countries ( )



Sam Vaknin

Sam Vaknin ( ) is the author of Malignant Self-love: Narcissism Revisited and a Visiting Professor of Psychology