Europe’s deflation danger

Falling prices in the eurozone has increased the real value of debt in countries already struggling to cope.

"It is past time to recognise the deflation danger facing Europe," says French economist Jean Pisani-Ferry. In November, the annual inflation rate in the eurozone had slid to 0.9%. In the autumn of 2012, it was over 2%.

Greece, Ireland and Cyprus have already suffered outright deflation (falling prices). On current trends, Spanish and Italian prices will soon be falling. With demand so subdued, inflation is set to keep melting away, says Capital Economics.

The main danger with deflation is that it raises the real value of a fixed sum of debt. So the huge debt burdens already crushing the south will grow. And if the economy is already shrinking, debt as a proportion of GDP will soar.Italy's public debt, for instance, has risen from 119% of GDP to 133% in just over two years, says Ambrose Evans-Pritchard in The Daily Telegraph.

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With the south in the grip of deflation, concerns that these countries will default could rapidly return, sending bond yields, or long-term interest rates, upwards and further undermining economies.

Meanwhile, the periphery can't get its debt written off and can't inflate its way out. Eurozone countries have no control over interest rates and no longer have their own currency. With Europe far more export-dependent than other regions, the south desperately needs a weaker euro to fuel a recovery.

Unfortunately, the euro has climbed by 6% against the dollar this year. A strong currency negates any gains in competitiveness stemming from reduced labour costs. According to France's industry minister Arnaud Montebourg, every 10% rise in the euro costs France 150,000 jobs.

Evans-Pritchard highlights a Deutsche Bank study noting that Germany can cope with a euro-dollar rate of up to $1.79, while the "pain threshold" for France and Italy is a respective $1.24 and $1.17. The rate is currently $1.37. And a high currency reduces inflation further.

With interest rates already at rock-bottom and banks still reluctant to lend, the only way the European Central Bank (ECB) can help the weaker states is by weakening the currency.

The trouble is that, having promised to do "whatever it takes" to save the eurozone, the foreign-exchange markets appear to be testing the ECB's resolve by keeping the euro buoyant. The current state of affairs makes it more likely that the ECB will be forced into quantitative easing which bodes well for European stocks.