Monday, 11 November 2013

EUROPE: Cheap Money & Fear of Deflation

Last week's ECB interest rate cut was aimed at averting deflation and shows that the central bank is following the risky policy of monetary expansion adopted by Japan and the United States. Despite the latest figures, inflation is by no means banished.
 
The rate cut followed heated debate in the ECB's Governing Council which includes the heads of the euro zone's national banks. The decision boosted share prices and caused the euro to depreciate sharply. But it also summed up the powerlessness of the euro's supreme guardian.
 
European Central Bank has every reason to take this step, because the greatest danger to the euro zone at the moment is that of deflation. Indeed, it is sinking rather than rising prices that are threatening Europe's economy. Last week the EU's Eurostat statistical office released its inflation figures for October -- with prices rising by just 0.7 percent, markedly below the approximately 2-percent increase the ECB aspires to in order to ensure price stability.
 
In his battle against the euro crisis, ECB president, Draghi, has pumped more money into the financial system than any other ECB president before him. He didn't just embark on a high-speed reduction in interest rates to almost zero; he also launched all kinds of special loan programs for banks. Hundreds of billions of euros poured into the monetary system in that way. But critics see the move as yet another sign that Draghi is increasingly following the example set by his central bank colleagues elsewhere around the world.

But now, suddenly, the euro zone is showing the first symptoms of a quite different disease: deflation, meaning a broad decline in prices which deters people from spending money. That phenomenon paralyzed Japan's economy for almost two decades and turned the former economic paragon into a problem case. It's a nightmare scenario for the euro zone.

Outside the euro zone, central banks have shown far less restraint in intervening in their respective economies -- and their efforts appear to have met with considerable success.

In Japan, Haruhiko Kuroda has been particularly aggressive. The Bank of Japan's governor purchases some €55 billion ($73.6 billion) worth of securities and government bonds from banks each month, thereby reinforcing a massive stimulus program launched by Shinzo Abe, the new Prime Minister.

Abe wants to put a stop to his country's economic stagnation by massively depreciating the yen and investing in gigantic infrastructure projects. As a result, Japan's debt has soared to the unimaginable sum of some €7.8 trillion -- but the economy has finally awoken from its chronic slumber to show marked growth. Between April and June, Japan's GDP grew 3.8 percent, a bigger growth rate than any other industrial nation. Companies like carmaker Toyota, boosted by the cheaper yen, are finally performing better after years of woe.

In United States, Ben Bernanke, the head of the US Federal Reserve, is spending $85 billion per month on mortgage-backed securities and government paper. The key interest rate in the world's biggest economy has long been at a historic low of 0.25 percent.

In the US, too, the economy is picking up after the traumatic financial and economic crisis of recent years. Unemployment is slowly declining, the housing market is recovering and industrial production is rising. Despite these gigantic stimulus programs there is no sign of inflation in the US either -- the figure hasn't risen above two percent in any month this year.

The phenomenon confronting Bernanke and Draghi is easy to explain. They can't inject their money straight into the economy and have to go via the banks instead. But if those banks hoard the cheap money instead of lending it to businesses, the system doesn't work.

This doesn't just pose the question how much of the recovery is really down to the Fed's policy. It also suggests that the risk of medium-term inflation hasn't been averted just because the current figures are headed in a different direction.

The dangerous monetary policy medicine can have further side effects: a dramatic depreciation in the value of the currency, and so-called financial repression, whereby inflation exceeds the interest rates paid on secure investments and eats into the assets of small savers, among others.

But Draghi's biggest problem is his currency zone. Whether Tokyo or Osaka, the whole of Japan has the same problem and needs the same medicine. But in the 17 countries of the euro zone conditions differ widely. The countries all have the same currency but they're not equally competitive.

So the euro zone needs inflation and deflation at the same time -- depending on what country you're looking at. But what price direction is more dangerous for Europe? The euro crisis managers want downward pressure on prices in Greece or Spain, where governments, private households and companies are cutting back on expenditure and wages have fallen. That makes those countries more competitive, but it causes a decline in price levels and lower inflation rates in those countries.

The problem is that if deflation lasts for any length of time the debt mountain will get even bigger and be harder to reduce. And if investors start worrying again that the government may default on its debts, the countries could quickly sink into the same mess they were in last year. That's why ever more European economists believe the ECB has no option but to follow the examples of Japan and the US.

The ECB and the European Commission, the EU's executive, share that view, which is why they want to conduct thorough reviews of the banks' financial health, and to get them in shape over the next 12 months. Until that has been achieved, the ECB, it seems, wants to keep buoying euro-zone sentiment with cheap money. It's also under pressure because the Fed and the Bank of Japan are proceeding so aggressively. The strong euro is a result of this policy. The more expensive the euro, the cheaper the imports into the euro zone, which in turn increases the risk of deflation.

By Guylain Gustave Moke
Political Analyst/Writer
Investigative Journalist

Photo-Credit: European Central Bank in Frankfurt Stock Photo