Courtesy Reuters The euro sign landmark at the headquarters of the European Central Bank in Frankfurt.

The Euro Deflation Crisis

Europe, Japan, and the New Lost Decade

A specter is haunting Europe -- the specter of deflation. Countries throughout the European Union have been struggling for the past several years with stagnant or falling prices. In Hungary, inflation has fallen to its lowest level since 1974. In Bulgaria, Cyprus, Greece, Ireland, and Latvia, consumer prices fell on a year-over-year basis in 2013. Over the same period, consumer prices remained static in Portugal and Spain, and they rose by the statistically insignificant rate of 0.5 percent in Denmark, Lithuania, Slovakia, and Sweden. Aggregate inflation in the EU has declined to a five-year low of 0.5 percent, well below the target of two percent set by the European Central Bank (ECB).

As long as incomes remain stable, deflation has a positive impact on consumers’ purchasing power; they can buy more goods and services as prices fall. Their savings also increase in value as prices decline, unless banks begin to charge negative interest rates -- basically, a fee for holding money. But deflation can be devastating for citizens with loans: as the value of their money remains stagnant or even decreases, they must continue to meet their debt obligations, the nominal value of which does not change. At the same time, whatever assets they have pledged as loan collateral decline in price, prompting lenders to demand further security against default. Deflation is also bad news for individuals and companies who do business across borders. Imports may become more expensive, and exports can generate lower revenues. Deflation also threatens citizens and companies with loans and other credit facilities.

For evidence of the ill effects of deflation, look to Japan in the 1990s, which closely resembles Europe today. There, too, the financial sector struggled under a large burden of bad loans. Like Europe, Japan also faced an aging population that consumed less. Another disquieting similarity is that the ECB, like its Japanese counterpart, seems unwilling to dramatically counteract these ominous monetary trends. The ECB has some reasons for its reticence -- but they aren't good enough.

MISSED OPPORTUNITIES

The ECB has already missed its best opportunity to effectively ease Europe’s money supply to counteract deflation. Two years ago, inflation in Europe dipped below the central bank’s two-percent target, and the European economy was at the lowest point of its four-year downturn. But the ECB was strongly influenced by Germany’s Bundesbank, which has historically been much more concerned about inflation than deflation. Now that the economy has started to revive and inflation has likely reached its lowest point, monetary expansion would not have much of a positive impact, at least not for Europe's leading economies.

For Europe's smaller economies, monetary expansion might still facilitate a recovery. If the ECB adopted a quantitative easing program involving the direct purchase of national bonds and collateralized loans, Spain, which has a huge stock of such debt, might come out ahead. But the implementation of such a strategy would be far more challenging in Europe than in the United States or Japan because of structural problems within Europe’s banking sector. Financial institutions within Europe’s fragmented banking sector still hold savings within the confines of their national borders.

It is also unclear whether quantitative easing is likely to have a significant impact across Europe right now. In the United States, quantitative easing seemed to help the most during and immediately after the financial crisis, because it brought stability to asset prices and to the financial sector generally. Beyond immediate damage control, though, quantative easing has had a relatively small effect in the United States. Japan’s recent policy of quantitative easing, which was much more ambitious than that of the United States had its greatest impact last year, stimulating GDP growth, at least temporarily, and boosting inflation to 1.5 percent per year, its highest level in years. Yet despite these achievements, quantitative easing has not been sufficient to bring an end to Japan’s long-term stagnation.

The ECB, furthermore, has already pursued a type of quantitative easing, which might have accomplished all the EU can hope to achieve through such policies. The ECB’s most effective measure to date was its program of long-term refinancing operations, which greatly improved the liquidity of the banking sectors in Europe’s smaller economies while decreasing the risk associated with their government bonds. For these effects alone, the policy was a success. But it had only a minor impact on inflation and GDP growth. Further rounds of quantitative easing, then, would likely lead to effects similar to those in the United States and Japan. It might contribute a few percentage points to GDP growth and the inflation rate, but it would not have any lasting effects on Europe’s economic recovery.

BETTER LATE THAN NEVER

Nonetheless, further quantitative easing by the ECB would be worth the effort. First, for Europe's weakest economies, an increase in economic growth by even a few tenths of one percent would make a tremendous difference. Second, further quantitative easing would allow the ECB to refine its use of extraordinary monetary measures. It could identify which assets are the most effective to buy and at what quantity. If the ECB is ever called on again for quantitative easing, that information would prove to be very useful.

But the ECB should be cautious. Unlike the U.S. Federal Reserve, the ECB does not have the legal authority to buy broad asset types, such as federal bonds and mortgage-backed securities. Instead, it would likely have to focus on more defined instruments, such as corporate bonds. And that would raise the political pressure on the central bank to choose assets based on political expediency, rather than sound financial and economic reasoning.

Moreover, European governments will have a hard time rallying citizens around deflationary policies. Over the last two decades or more, Europeans have been told by their governments that inflation leads to negative consequences, such as rising prices, the devaluation of savings, and a slowdown in social and economic development. Now, governments will have to convince them that, rather than fight inflation, the EU should hope for it.   

EXTRAORDINARY MEASURES

The ECB continually emphasizes the differences between Japan and the eurozone. Yet it shouldn't deny the very clear similarities. Demographically, Europe and Japan both have aging populations that are consuming less, which produces slower economic growth. Europe and Japan are both heavily indebted as well, which increases the negative effects of deflation.

Although the ECB did not mention deflation in its 2013 economic report, current conditions make it a real possibility. European countries, especially the Baltic States, already see the reduction of wages and prices as an unavoidable form of internal devaluation necessary to correct economic imbalances with other EU countries. Meanwhile, Europe’s banking sector remains fragile. Once inflation reaches zero percent -- which may happen soon -- the ECB would be forced to acknowledge the risk of deflation. By then, however, it may be too late.

That's why the ECB must take steps now to counter the possibility of deflation. It should start by putting downward pressure on interest rates until they fall slightly below zero. This would encourage consumers to spend rather than save their money, which would lead to higher economic growth and lower unemployment. The ECB should also continue purchasing government bonds under the Securities Markets Programme (SMP), without “sterilizing” those purchases by removing an equal amount from banks of those countries. But since these measures alone will not reverse the slide toward deflation, the ECB should also proceed directly to another round of quantitative easing.

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