Expect deflation in Europe, warns George Soros

Deflation is on the horizon for the eurozone, warns George Soros. And it could be made worse by the austerity measures proposed by Germany.

George Soros may be the man who broke the Bank of England' but these days Europe is his priority. The legendary investor, who famously bet on the Black Wednesday currency crisis in the 1990s, is now so concerned about the European sovereign debt debacle that, rather than shorting the euro, he has come up with his own solution to the crisis.

The 81-year-old chairman of Soros Fund Management fears that if the crisis continues, it could lead to a collapse of the financial system and a breakup of the eurozone. In a speech at the Davos World Economic Forum, he claimed that while the European Central Bank's recent lending measures had "relieved the liquidity problems of European Banks" they would not cure the "financing disadvantage" the "highly-indebted member states" face. He believes that the intervention so far has left the eurozone's weaker members "relegated to the status of third world countries that become highly indebted in a foreign currency".

Soros fears that having Germany, rather than the International Monetary Fund, dictating terms risks creating "economic and political tensions that could destroy the political union". What's more, he warns that the spectre of deflation is now on the horizon and could be exacerbated by the austerity measures Germany wants to force on errant eurozone members.

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"The policies that Germany is pushing on the eurozone strict fiscal austerity [are] creating a deflationary debt spiral because it puts pressure on wages and profits," he told CNBC. "So as the GDP declines, the debt ratio goes against you, then you need more austerity and that makes the economy decline some more and that is the trap we are caught in."

The solution Soros has been touting features in his new book, Financial Turmoil in Europe and the United States, published in February. He recommends that the struggling eurozone countries refinance their debt by issuing treasury bills paying just 1% interest, which could then be bought by the European Financial Stability Facility (EFSF). Soros believes that this strategy, spearheaded by the late Italian central banker Tommaso Padoa-Schioppa, would reduce the debt burden and lead to a return in confidence.

However, no matter what happens, investors shouldn't bank on a eurozone recovery anytime soon. "To expect a rebound (in growth) is unrealistic," says Soros. "The EU is undemocratic to the point where the electorate is disaffected and ungovernable."

But it's not just Europe Soros also tells Newsweek that he expects there to be violent riots on the streets of the US, where the Obama administration is "exhausted", unless the problems of debt and unemployment are resolved. If anything can help pull the world out of recession, Soros believes, it's emerging markets such as Russia and Africa. "While the developed world is in a deep crisis, the future for the developing world is very positive," he says.

Piper Terrett is a financial journalist and author. Piper graduated from Newnham College, Cambridge, in 1997 and worked for Germaine Greer and for Adam Faith’s Money Channel before embarking on a career in business journalism. 

She has worked for most top financial titles, including Investors Chronicle, Shares magazine, Yahoo! Finance and MSN Money. She lectures part-time at London Metropolitan University and is the author of four books.