European Deflation

Posted on Posted in General

Last week, the President of European Central Bank (ECB), Mario Draghi, announced an unexpected slashing of interest rates across the Eurozone. The discount rate was cut down to a record low of 0.05% from 0.15% due to fears of deflation in the economy.

But the real question is: Why is deflation bad for an economy? Aren’t lower prices good for all of us?

The answer is NO.

Deflation happens when there is a higher level of debt in the economy. People have to spend a significant portion of their income to service debt, which results in lower consumer spending. This reduces the demand of goods and services and results in decrease in prices. When prices fall down, companies generate less revenues (lower selling prices), which forces them to cut down their costs by either letting people go or slashing wages. On top of it, the debt levels in the economy don’t shrink. In essence, people are earning less money (job cuts, lower wages, etc.) and they still have to service their debt. All in all, this cycle causes consumers to spend even less due to lower income levels and the economy continues to go down in a domino. This is called the debt deflation spiral.

We witnessed a debt deflation spiral between 1929 to 1933 in the US during the Great Depression. Without going into further details on the historical events of depression, it won’t be very wrong to say that Europe is close about enter into a similar situation.

Now to prevent this from happening, Draghi slashed the interest rates down to near zero levels. All things considered, it is very likely that the Eurozone is getting ready for Quantitative Easing (QE), which essentially means printing more money. QE has its own benefits but they do not come without major threats to the overall economic system. Excessive liquidity and money supply in the market is mis-used by banks to take on major risks, which was originally the problem behind the economic crisis of 2007-08.

Deflation in Europe is a also symptom to one of the biggest global economic challenges, which is stagnation. If economies need near zero interest rates to sustain growth (US, Japan and now Europe), then we are in deep trouble. I am not arguing against zero interest rates or slashing of interest rates in the wake of a crisis. The general principle of economics state the monetary policy has to be relaxed when the economy slows down. However, when the zero interest rates become a norm, then things change. Why?

Mainly because when zero interest rates become normal, the ability of a central bank to expand the monetary policy further becomes fairly limited. Policymakers are left with only the option of printing more money to come out of an economic crisis, which is not a very effective measure. QE takes a significant amount of time to work and this has been recently witnessed in the US (QE1, QE2 and then QE3) and previously in Japan (Abenomics). Draghi will most probably face the same problem with Eurozone. Secular stagnation, which is a serious threat to Europe means negligible or no economic growth. It is difficult to maintain sufficient demand to produce at normal output levels in the economy. The over-capacity will keep unemployment levels high and income levels low. Without consumer spending, the recovery becomes painfully slow.

Looking forward, I do believe that QE in the Europe will benefit the stock prices. But will it help the general economy (spending levels, jobs, etc.) is still a big question. For everyone’s sake, let’s hope that the European near zero interest rates and QE policy work better than it did in US and Japan.

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