Friday, March 2, 2012

Europe's deflation 2012

A predictable, but nevertheless depressing, event is to see Europe slipping into deflation.

Monthly inflation in the EU area was -0.8% in January 2012. (EU Stat) The 12 month inflation figure was 2.6%, which includes some cost-push inflation. Inflation will continue to fall over the coming months However, there are few signs of economic recovery. Countries in the periphery of the EU are at greater risk of deflation because of the continued austerity, high exchange rate and fall in economic confidence. The ECB has been debating whether to pursue quantitative easing, but there is a deep-seated reluctance to pursue this unorthodox monetary policy.

The problem is that even quantitative easing can take a long time to have an effect on economic activity. The experience of the UK and US is hard to judge, but it has had an effect in preventing a deeper and longer lasting recession. Any fears of inflation resulting from quantitative easing seem hard to justify as the economies struggle along.

A short reminder of the timeline of the current economic crisis

See: Causes of Europe's deflation

How Will Deflation Affect the Eurozone?

  • Increase Debt to GDP ratios. Falling nominal GDP will increase the debt to GDP ratio. Even if countries like Greece and Portugal manage a primary budget surplus (which is very hard to imagine), they would still see rising debt to GDP ratios, and probably a continuation of higher bond yields
  • Decline in consumer Spending. Deflation plays a key role in delaying spending decisions. Faced with falling prices, people tend to delay spending, waiting for goods to become cheaper.
  • Higher real Interest Rates. With deflation, real interest rates are effectively higher. 
  • Higher unemployment. With continued deflation and lower growth, EU unemployment will remain high.
  • More on economic costs of deflation.