European Deflation Denial

by: Desmond Lachman

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. For not only does he seem to be glossing over the record gaps in Europe's labor and product markets or over the pronounced European disinflation that has already occurred over the past year, he also seems to be turning a blind eye to the marked deceleration in Europe's credit and money supply aggregates.

Last week's release by the European Central Bank of European money and credit supply aggregates for October should have been a wake-up call for Mr. Rehn as to the real risk of European deflation for those aggregates revealed that European credit contracted by around 2% over the last twelve months, or at the steepest pace of contraction ever for the Eurozone. Moreover, M3 money supply growth was under 2%, or a far cry from the 4.5% M3 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 particularly in Italy, Portugal and Spain. And this 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 become 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 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 12 months the European banks will seek to further shrink their balance sheets in an effort to avoid being found short of an adequate capital level.

Hopefully, Mr. Rehn's complacency about the deflation risk 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 public and private sector in the European periphery now needs.