The Potential Effects of Deflation in the Eurozone

By Charis Mountis, Head of Dealing at Forex Time Limited

Deflation happens when the general price levels fall for a prolonged period of time. Although lower prices may sound good, when they come as a result of deflation rather than efficiency in production, they adversely affect the economy. In the currently financial instable climate, deflation in the Eurozone would not only debilitate the European economy, it would also have significant knock-on effects on other markets as well.

When the prices of goods drop, the companies that sell them make smaller profits and are forced to lower employee salaries or fire people. Increasing unemployment, in turn, causes consumers to limit their spending to the most necessary items only, which further restricts cash flow in the market, hinders growth, and causes prices to drop to even lower levels, thus perpetuating the vicious deflationary cycle. The Eurozone has been experiencing low inflation rates for over a year, and the first month of this year has shown signs of deflation with price-drop levels reminiscent of those at the beginning of the five-month recession that began in July 2009.

Charis Mountis

With the majority of the Eurozone’s economic output coming from consumer spending, as it does in most developed nations, the economic damages caused by deflation will also be felt by countries in trading relationships with the Eurozone, such as the U.S. and China. Considering that China is battling against its own low inflation rates, with the People’s Bank of China having decided to ease its monetary policy in early February in order to boost liquidity, deflation in the Eurozone could trigger stagnating economic growth worldwide.

Another side-effect of deflation is the debt trap. With the value of currency on the decline, both interest rates and debts rise in real terms. To compound the problem, diminished income makes it even harder to pay off debt, putting the stability of the economy at risk. The debt trap does not only ensnare private credit, but extends to public debt as well, as diminishing income also means diminished public revenue as a result of lower GDP and the swelling of public expenses for unemployment benefits. With three European countries currently under bailout programs, and others struggling under heavy debt burdens, deflation in the Eurozone could lead to a serious impact on the world financial system as more and more countries become unable to pay their debts.

In response to the negative inflation rates, in late January the European Central Bank announced a quantitative easing program of the order of €60 billion per month to last at least until September 2016. The program is not only meant to boost confidence within the Eurozone but also to support the value of government bonds issued by the member states. At the same rate, however, the program has had a short-term weakening effect on the value of an already-sliding euro. With the US Dollar continuing the steady climb it began at the end of 2014, European exports to the U.S. will become even cheaper, which could potentially jeopardize U.S. inflation rates by lowering consumer spending.

Deflation in the Eurozone could have negative consequences not only for the 18 countries that directly depend on the euro, but also for the already-strained global economy. A suffering European economy would curb consumer spending, risk increased unemployment, and push the Eurozone back into recession. With some countries in the Eurozone already in bailout programs and with the implementation of a new quantitative easing program that could depreciate the common currency even further, recovery from a potential recession will not be quick and will probably deeply affect both the U.S and China which trade with the Eurozone.

According to ECB President Mario Draghi, deflation is a concern but he sees the inflation rate starting to recover by the end of 2015 as Europe gets back into growth territory. Barring any more surprises like the rapidly falling oil price, the good thing is that the ECB has realized the threat and is responding to it in order to get the inflation rate back up to just under two percent.

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