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By Simon Johnson

In January, Lucas Papademos, Vice-President of the European Central Bank ECB), strongly suggested that inflation would not fall much below 2% in the eurozone (see the end of this post). Translated from the language of central bankers, he implied that the risk of deflation in the eurozone was virtually nil.

Now Jean-Claude Trichet, head of the ECB, with reference to the latest eurozone (0%) inflation rate, says that we should disregard the data because a recovery is just around the corner.

Alternatively, we are close to the baseline eurozone view laid out in my January presentation (part of a panel discussion with Mr Papademos). You can break this down into three specifics.

  1. Private sector demand is weak; it’s hard to see who will lead the recovery within the eurozone. In addition, the demand for European exports has fallen much more than expected, as seen – for example – in the big decline in German Q1 output.
  2. The ability of the public sector to offset this decline with discretionary fiscal policy is quite limited, due to balance sheet constraints in some countries (look at the latest credit default swap data from weaker euro sovereigns; CDS primer) and clear policy preferences in others (i.e., how Germany worries about inflation, even when there is none).
  3. Banks look troubled across many eurozone countries, and as the real economy surprises on the downside these problems will increase – with presumed implications for government bailout programs and balance sheets (the IMF was quite negative, see Tables 1.3 and 1.4 on pp.28 and 34 respectively, on European banks before the latest round of bad news). Remember that the European economy depends on banks much more than does the US.

If the world turns around and/or oil prices continue to rebound, the eurozone can presumably avoid deflation. But it’s hard to see inflation rising any time soon due to the eurozone’s own dynamic.

And if deflation takes root, it is hard to see this proving more tractable or less damaging than deflation in Japan during the 1990s. Which part of Japan’s lost decade now looks easy to avoid in Europe?

Source: Risking Deflation in the Eurozone