ECB Ignores Deflation at Its Own Peril

The talking points coming from the German delegation at the ECB are all sunshine and roses. Everything is fine, business as usual in Europe, a mere speedbump on the road to prosperity:

• European Central Bank Executive Board member Juergen Stark said the bank will only implement additional non-standard policy measures once interest rates have reached a floor. "There are “no signs” of deflation in Europe and the ECB must not lose sight of its central aim, which is to preserve price stability, [Jürgen Stark] added." (Bloomberg, 4/29)
• The ECB’s Governing Council is split over how low to cut the key interest rate, currently at 1.25 percent, and what new measures to take to stem Europe’s worst recession since World War II. Germany’s Axel Weber wants to make 1 percent the floor for the benchmark and is against buying bonds, while others such as Athanasios Orphanides of Cyprus don’t want to rule out deeper cuts or the possibility of buying assets. (ibid.)
• 'Deflation would mean that we face falling prices over an extended period of time. We do not expect this.' - European Central Bank Executive Board member Gertrude Tumpel-Gugerell (Reuters, 4/29)
• Nowotny also said that he doesn’t foresee deflation in the 16-nation region. (Bloomberg, 4/28)

But the writing is already on the wall:

• Loans fell 0.2 percent from February, when they declined 0.1 percent, the European Central Bank said in Frankfurt today. While a separate report showed banks expect to tighten credit standards less forcefully in the second quarter, the European Commission said consumers now expect prices to fall for the first time since at least 1990.

  “The hard lending data shows that the ECB is facing a deflation problem and will have to act more aggressively,” said James Nixon, an economist at Societe Generale SA in London and a former ECB forecaster. “Unfortunately, the Governing Council will probably latch on to the more positive bank survey and do a lot less than is necessary in the current environment.”(Bloomberg, 4/29)
• Dublin’s Deflation Sounds Alarm as ECB Hesitates, Bloomberg
  
• Spanish clothes price war fuels deflation fears, AFP
• Pay cut warning to workers as UK suffers deflation, Daily Record (OK, not the Eurozone, but closely linked to it)
• Spanish CPI shows first fall in half century, Forbes
• Spain's Falling Prices Fuel Deflation Fears in Europe, NY Times
• etc. etc.

There is already public dissent among the ranks:

• The ECB’s Governing Council is split over how low to cut the key interest rate, currently at 1.25 percent, and what new measures to take to stem Europe’s worst recession since World War II. Germany’s Axel Weber wants to make 1 percent the floor for the benchmark and is against buying bonds, while others such as Athanasios Orphanides of Cyprus don’t want to rule out deeper cuts or the possibility of buying assets. (Bloomberg)
• [European Central Bank board member Lucas Papademos] repeated the ECB's forecast for brief euro-zone deflation around midyear, saying it is "expected to be temporary and reflecting plunging oil prices and not a protected decline in prices that would hurt demand across the economy. (BusinessWeek)
• President Jean-Claude Trichet has indicated the bank will cut its benchmark rate again and promised to announce new non-standard measures combat the crisis. (Bloomberg)

The Germans and Austrians, not yet experiencing the brunt of the problem, see no need to take American-style measures. They are positively laissez-faire about the whole thing. "Let the Spanish and Irish economies collapse! It's the result of their own poor decisions in the past! Serves them right!"

Weber even wants to halt rate cuts at 1%, much less introduce unconventional interventionism. The French are publicly ambivalent, riding the fence monetarily while quietly shoring up their domestic industry with questionably-legal protectionism that flies in the face of the EU. Meanwhile, less well off countries such as Spain and Ireland are in full blown deflation. The big countries neglect to notice that their own economies are now intrinsically linked to those, and it is only a matter of time before it spreads.

They will not tolerate the ECB's indifference forever. Either the ECB will take some much more substantial action against deflation (which will be neither brief nor contained to Ireland and Spain if it is allowed to continue much longer), much more drastic than cutting rates a quarter point to 1%; or countries will start walking out of the currency union so as to be able to rescue their own economies. It's that simple. In any case, the outlook is bad (relative to a world basket of currencies and commodities, not necessarily just the US dollar) for the Euro.

Disclosure: No stocks mentioned.

Comments

[bagnap:]

Paul, I kinda think that your argument is a little inconsistent in a couple of ways.

Firstly, you seem to imply that the ECB is more likely than not to keep rates on hold (or maybe with a slight downward bias) but without drastic monetization measures.

Everything else remaining the same, this would result in upwards pressure on the Euro relative to the dollar, especially if you are contrasting the european policy measures with the US.

I take your point that there may be some risk of the EU coming apart, but predicting that on the basis that Spain and Ireland are having a hard economic time right now....surely their policy makers would look north to Iceland and say something like:

"Well, we are a small country coming out of a oversupply of credit and dealing with its consquences. Thank God we're in the EU. Look what would have been imposed on us (i.e. IMF high rates etc) if we'd been on our own".

I'd be interested to hear your view on this.

Apr 30 09:18 PM

[LKofScotland:]

interesting article. of course there is no centralized banking authority in europe--hence the panic buying of dollars by europeans of all people. strange considering what most consider to be the strength of the european economy. of course that was before the collapse of wall street. soon people will have questions. how existential, no?

May 01 12:41 AM