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Europe Is In Deflation Denial

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An illuminated euro sign is seen in front of the headquarters of the European Central Bank (ECB) in the late evening in Frankfurt January 8, 2013. REUTERS/Kai Pfaffenbach

By Desmond Lachman, Resident Fellow, American Enterprise Institute

One has to wonder what Olli Rehn, the European Union’s Commissioner for Economic and Monetary Policy Affairs, is looking at when he boldly asserts that deflation is not a risk for Euro member countries. Not only does he seem to be glossing over the rapid pace of disinflation that has already occurred in Europe. He also seems to be turning a blind eye to Europe’s unusually large labor and product market gaps as well as to the marked deceleration in Europe’s money and credit supply aggregates.

Over the past year, European inflation has come down sharply in response both to a rise in its unemployment rate to a record 12.2 percent and to the very large gaps characterizing its product markets. Indeed, European consumer price inflation decelerated from 2.5 percent to 0.9 percent in the year ended October 2013, or to less than half the 2 percent inflation target of the European Central Bank (ECB).  Meanwhile, in countries like Greece, Ireland, Portugal, and Spain there has been an even sharper deceleration in inflation. That deceleration has now moved those countries either into outright deflation or else to the very cusp of deflation.

European policymakers’ apparent complacency about the deflation risk is particularly surprising considering how highly indebted are the public and private sector’s in Europe’s struggling economic periphery. As Federal Reserve Chairman Ben Bernanke learnt from the Great Depression and from the more recent Japanese experience with deflation, in a world of falling prices and wages it becomes extremely difficult for households and corporations to dig themselves out of their heavy debt burdens. And without a resolution of the debt problem, it becomes very difficult for these countries in the European periphery to engineer meaningful economic recoveries.

European policymakers do seem to recognize that even though Europe might experience a moderate economic recovery next year that recovery will neither make much of a dent in its very high unemployment level nor will it close its very large product market gaps. Yet those policymakers seem to cling forlornly to the hope that somehow high unemployment and slack product markets in the year ahead will not exert the same downward pressure on European wages and prices that they exerted over the past year.

That hope seems to be causing European policymakers to minimize the deflation risk and it is inducing the ECB to be late in cutting interest rates. More importantly yet, it is causing the ECB to eschew resort to unorthodox monetary policy measures of the sort being used by the Federal Reserve to avoid deflation from taking hold.

Last week’s release by the ECB of money and credit supply aggregates for October should have been a further wake-up call for European policymakers as to the real risk of deflation. For those aggregates revealed that European credit contracted by around 2 percent over the last twelve months, or at the steepest pace of contraction ever for the Eurozone. Moreover, M3 money supply growth was under two percent, or a far cry from the 4.5 percent growth that the ECB considers to be consistent with monetary stability.

Needless to add, the pace of money and credit supply growth in the European periphery was considerably below the European average. This was particularly the case in Italy, Portugal, and Spain where credit is now contracting by between 6 and 12 percent a year. And this credit contraction is occurring at the very time that countries in the European periphery are still pursuing budget austerity and are already either experiencing deflation or else are on the very cusp of deflation.

More disturbing yet, is the prospect that, over the year ahead, Europe’s credit crunch will become even more pronounced. It will do so as the ECB conducts its asset quality review of Europe’s 130 systemic banks. This review is to be completed only by end-2014 and it is being done without first ensuring that the European banks are adequately capitalized. This has to raise the very real prospect that over the next twelve months the European banks will seek to further shrink their balance sheets and cutback further on extending credit in an effort to avoid being found short of an adequate capital level.

Hopefully, Mr. Rehn’s complacency about the risk of European deflation is not shared by ECB President Mario Draghi and the rest of the ECB’s board. For if they did share that complacency, the ECB would risk repeating the Bank of Japan’s mistakes over the past two decades of doing too little too late to avoid the very damaging consequences of deflation. And deflation would be the last thing that an overly indebted and struggling European economic periphery now needs.

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a Deputy Director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.