Does the European Economy Have a Deflation Problem?

Are the European Central Bank president's comments in line with reality?

Feb 10, 2014 at 11:07AM

"We have to dispense with the question, 'Is there a deflation?' and the answer is, 'No.'"

So says European Central Bank President Mario Draghi. The ECB claims all is well, but the economic condition on the ground may be more telling. With noncommittal comments by the International Monetary Fund on world growth and the unstable European stock market, Europe seems more on a razor's edge than before the economic crisis in 2007. 

Leaving benchmark interest rates at 0.25%, Draghi has acknowledged that inflation rates are lower than expected (0.7% this past January) but will climb in the coming months to a target of 2%. Despite this hopeful prediction, however, interest rates have never been lower. The ECB is even considering a negative interest rate (that is, forcing banks to pay for storage of money with the ECB) to inspire extensions of credit. Considering the 2.3% drop-off in lending to euro zone companies over the past year, the potential negative interest rate indicates the very real potential onset of deflation.

Why deflation is just as bad as (uncontrollable) inflation
The most misunderstood term in economics may be inflation. Inflation is like a seasoning for food: a little bit goes a long way. Eroding the real value of loans, inflation allows for cheaper money usage and creates a regenerative cycle for future investment. Being necessary to encourage further development of markets, inflation is good as long as it is under control. If not under control, prices skyrocket and markets begin to stagnate.

On the face of it, deflation would seem to be preferable to inflation any day of the week. Unfortunately, deflation causes growth to stall as businesses cut costs to maintain profitability. Cutting costs means reduced productivity in the long run, meaning that reacting businesses are only hampering themselves in the future as they are increasingly unable to react to demand. In essence, the onset of deflation is really the onset of a self-reinforcing downward spiral.

With much of the euro zone still in massive debt (due to measures employed to combat the 2007 crisis), this deflation could make things much worse as a still-indebted EU struggles to recoup stimulus investments. As the money supply becomes more dear, existing loans become harder to pay and loans in default put further pressure on already weak banks. Many say the ECB is aware of the danger, but the lack of consensus among the ECB Governing Council economists indicates confusion as to how to proceed.

Now what?
A deflating Europe would have continuing negative effects on a struggling world market. Despite hopeful growth projections from North and South American markets, the European market could couple with ailing Asian markets and potentially cause a new (at least regional) recession across two of the most productive areas of the world. A Deutsche Bank economist notes that extreme measures (including the aforementioned negative interest rate) are necessary to keep alive future stimulus options. While this is far from ideal for European policymakers, it might be the best option available. 

Draghi says there is nothing to worry about. "The risks of deflation or inflation are limited at this time."

Assuming he has read the situation correctly, can Europe really afford another period of stagnation?

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David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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