Dilemma Of The European Central Bank: Can It Do Anything To Stop Deflation?

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by: John M. Mason


Latest data indicate that European disinflation continues.

This has placed the European Central Bank at the center of concern over stopping the disinflation or possible deflation.

The problem may be bigger than this, as all Europe faces issues relating to political as well as economic reform, and this reform may take a longer time to resolve.

Thursday, June 5, the policy-making board of the European Central Bank meets to determine what needs to be done to combat the dire economic situation in Europe.

Economic growth for the eurozone is positive, but miserable. Unemployment is extraordinarily high. And, the rate of inflation continues to decline.

Yesterday, the May inflation rate was announced at 0.5 percent over the previous May. This figure is down from 0.7 percent for April. Economists are predicting that the June figure will be around 0.4 percent.

Policymakers are nervous, which, of course, makes investors nervous.

There has been a significant amount of talk about what the ECB is likely to do - lower its policy rates by 10 to 15 basis points, and to make negative the rate it pays on deposits banks keep with it. Any kind of quantitative easing seems to be off the board.

Analysts believe that a movement of this kind is already "priced into the market" by investors. Thus, the only real action likely to be seen when the ECB announces its decision will take place if the ECB does not live up to these expectations.

"If the ECB disappoints analysts expect the euro to strengthen, bond yields to rise and equity markets to fall."

If the ECB goes further than this, the opposite is expected.

The question behind all this, however, is whether or not any actions by the ECB at this point can achieve anything with respect to bank lending, economic growth, unemployment, or inflation.

If you believe that the economic problems facing the eurozone are cyclical problems, then you hold out hope that actions by the European Central Bank can possibly do something to stabilize the continent, help to improve the employment situation, and increase confidence.

I see this in another way. Europe has major problems to deal with that are not of a cyclical nature. There is a huge sovereign debt overhang in most countries in the eurozone. There are also massive corruption issues to face in government circles. The labor union situation is almost unmanageable in most countries. There are still major questions about the health of the banking system in Europe. And, in addition to all this, European businesses face the transition that is going on in the world connected with a substantial re-structuring of the world business.

And, if you exist within this environment, you are faced with an enormous amount of uncertainty about your business, your culture, and your world.

How can companies invest in new capital investment with all this uncertainty? How can banks lend with all this uncertainty? This is not the environment one finds when looking for a cyclical business recovery.

Historically low interest rates and plenty of financial market liquidity may help to pump up the prices of existing assets, but in a situation like the one we seem to be in, these actions on the part of the central bank can do very little to speed up economic growth or revive the market for labor.

And, most of the countries in Europe have "shot their wad" when it comes to fiscal policies. Most countries have issued so much debt that the amount of debt they have outstanding exceeds 100 percent of their Gross Domestic Product. Greece, one of the worst, has debt outstanding over 140 percent of GDP. Italy, it is suggested, will soon have debt outstanding over 130 percent of GDP. How much further can these countries go in attacking economic problems through the use of fiscal policy?

It seems like every so often, economies come to the point where it appears that no economic policies seem to work. In the 1920s and 1930s, John Maynard Keynes looked at his depressed world and saw that business expectations ("animal spirits") were so depressed that investment in capital goods from the private sector was severely limited. Furthermore, in the financial markets, central banks could not push down interest rates below certain levels, because people just held on to the additional monies rather than putting them out into the market to further lower interest rates. This he called a "liquidity trap."

His solution was to have governments spend using deficit spending to get some kind of money flowing in the economy, so that it could then be spent by the private sector. But, the governments he was relying on were not already almost bankrupt.

But then, this assumed that the economy was not going through a transition period in which major structural changes needed to be introduced to the economy. Keynes basically assumed that the government spending would put people back to work in jobs that they were already familiar with. Maybe that was why his policies have never quite had the impact that many people thought they would have. The future depends upon putting people into new jobs... not back into their old jobs.

Therefore, if we are going through such a transition period in the world economy, the application of cyclical economic remedies will have little or no impact in the near term on growth or unemployment.

Furthermore, if the governments of several European countries need to engage in substantial governmental and societal reform, as seems to be the case, continued monetary or fiscal stimulus would hardly seem to be the solution to Europe's problems.

Major transition periods, like the one we are now going through, take place maybe only once a century. But, they do take place as technologies, social structures, and world power structures change. During such times, there is only so much a government can do. Oftentimes, it seems as if the best a government can do is work to "not derail" the changes that are taking place. But, to do this really requires people to change their ways of thinking.

The real upside of these transitional changes is that there are plenty of ways to make money. However, they require investors to change the way that they look at possible investment opportunities.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.