Will Europe fall into a Japan-style slump?

Looming deflation threatens to derail the recovery in the eurozone.

"Viewed from one perspective, the euro area is a minor miracle," saysThe Economist. In 2012 it looked set to "collapse in a heap" as the southern states slid towards bankruptcy. Now it's not only intact, but it has a new member.

Latvia became the 18th country to join in January this year. And the economy is recovering after a double-dip recession lasting 18 months.

The rebound has been "feeble, but sustained". Eurozone output grew by 0.2% in the fourth quarter of 2013. Even Spain and Italy managed to return to growth, helped by falling bond yields (which lower borrowing costs across the economy).

Greece's ten-year bond yields have hit a four-year low, allowing the country to once again borrow from the market. This in turn reflects improving sentiment EU data shows business and consumer confidence at a three-year high.

Deflation is looming

Eurozone consumer prices rose by just 0.5% year-on-year in March. In the south, deflation has set in: prices are falling in Cyprus, Spain, Portugal and Greece.

This has raised the spectre of a Japan-style slump. Falling prices may not sound terrible, but the key problem is the impact on the debt burden. While inflation nibbles away at a fixed sum of debt as money becomes worth less in realterms, deflation does the opposite.

As their debt loads grow heavier, households and consumers become more reluctant to spend and borrow, further reducing overall demand and prices in a vicious circle.

Deflation also makes it harder for governments to get borrowing under control especially as households and companies hunker down. "Europe risks falling into a dangerous downward spiral," says Marcel Fratzscher of the German Institute for Economic Research.

Will Europe print money?

quantitative easing (QE)

"Historians will look at this episode and ask how the ECB could ever justify allowing headline inflation to ratchet lower" and let the money supply and eurozone-wide credit stagnate or even shrink, says Ambrose Evans-Pritchard in The Daily Telegraph.

QE in Europe could also tackle the problem of busted banks, as Liam Halligan points out in The Sunday Telegraph. It's not just the southern countries' financial institutions. Many French and German ones are broke but "too politically-connected to be allowed to fail".

So "out-of-thin-air wonga can be used to buy dodgy bank loans, allowing the smooth bankers to avoid the realities of their mistakes". These purchases, along with those of other kinds of bonds, would alleviate the credit squeeze as balance sheets become healthier.

But will QE happen? ECB President Mario Draghi recently hinted at more radical policies and made it clear the Bank would consider it. But "there will always be a suspicion that the Bundesbank could at any moment call a halt", says Roger Bootle of Capital Economics in The Daily Telegraph.

Germany's central bank, judging by recent utterances, appears to be less opposed to the concept of QE than in the past, but "you cannot overemphasise" its "theological" fear of inflation and money-printing imbued by Weimar hyperinflation. So instead of QE, we could well end up with "another euro fudge" that doesn't go far enough.

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