In June of 2014, the European Central Bank (ECB) cut the deposit rate below zero for the first time in a desperate bid to encourage borrowing and consumer spending. Nine months later, the ECB began its quantitative easing (QE) program to stimulate growth in the economies of the Eurozone.
A desired effect of cutting interest rates and governmental purchase of assets through QE is to avoid deflation, a concept that makes any central banker visibly uneasy when uttered. In a simple sense, deflation is the increase in the value of money and corresponding decrease in the price of goods and services for which consumers pay. Don’t we want deflation, then?
The first blush makes deflation all roses, but the thorns lurking are very real. First off, deflation increases the real value of debt held against the value of an asset. The home or car bought with a loan loses value, and a wave of foreclosures and repossessions lead to still lower values. Secondly, deflation leads to unemployment. Falling prices lead to producers being forced to lower prices further due to an increasingly competitive landscape. Falling prices mean less profits, which leads to cost cutting, resulting in layoffs. This leads to consumers having less money, thus extending what’s known as the deflationary spiral.
Is this the fate of Europe in the near future? Mario Draghi, President of the ECB, hopes that driving the deposit rate further into negative territory and purchasing sovereign and corporate bonds will help Europe avoid the scourge of deflation and the recession that generally follows. Will it be successful? Here are some reasons why it could be, as well as why it very well couldn’t:
Europe will get out of deflation because:
1) The Eurozone, like the U.S., has the economic weight to throw around to keep buying back bonds and lowering interest rates. The 28 countries that make up the economic zone clock in at 25% of the entire global output.
2) The European Central Bank can fake it ‘til it makes it.’ With the U.S. on a policy path to continue raising rates while rates fall in the Eurozone, the differential should be a positive for exporters all over Europe. Business begets business, and a drop in the euro has boosted profits for businesses importing to the U.S. Make sure you understand how fluctuations in currency can affect your business. If you do business in Europe you can save significantly on your transfers with an international payments service like World First USA, Inc.
3) The ECB has made it clear they will do what is necessary to foster inflation. This increases consumer and business confidence, which should itself help inflation with more consumer spending and wage growth.
Europe will fall into a deflationary spiral because:
1) Europe has a high household savings rate (over 10%), more similar to Japan than the United States. A high savings rate makes it more difficult to stimulate the economy from the consumer up via interest rates.
2) Europe’s current asset-buying program focuses too much on corporate debt. The European Central Bank is buying up debt of the big companies. This is all well and good, but countries like Italy are made up of small and medium enterprises (SMEs) which won’t benefit from this program, and thus the;
3) Debt levels are already high in many European countries, namely Portugal, Ireland, Italy, Greece, and Spain (known collectively as PIGS). Credit was eased after the global recession in 2008, resulting in more and more debit piling up. Will adding more debt to already dangerous levels lead to a credit crisis in Europe?
It is unclear what the future may bring, but it is this lack of clarity that makes planning for the future so important. Keep an eye on any news that mentions Europe’s inflation; Central bankers around the world certainly are.
Matthew Worley is a Private Dealer with World First USA, Inc.
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