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The International Monetary Fund seems to think deflation is a credible threat for the euro zone. But the president of the European Central Bank and Germany’s finance minister keep telling us the euro zone is not headed into deflation.
I see their intent — maintain social order so as to maintain financial system order so as to maintain economic order so as to maintain social order. But the mere expectation of deflation has the potential to get investors running for cover. And the fear would just snowball from there.
From Germany’s finance minister, Wolfgang Schauble, in Reuters:
“There is no deflation danger in Europe. We understand deflation as a reluctance to spend in the anticipation of falling prices. And there are no signs of this.”
Well, at least he understands the risk … assuming there were one, after all.
But really, it’s hard to blame Schauble and ECB President Mario Draghi for talking tough against potential deflation now. They’re feeding the people what they “need” to hear despite reality suggesting otherwise. Euro-zone inflation decreased to 0.7 percent last month, dropping even further from the zone’s target of about 2 percent.
To be sure, euro-zone policymakers are doing what is in their power in hopes of stemming a reluctance-to-spend spiral amid falling prices. The problem: There is too much outside their power.
Consider: Deflation would put the spotlight on the ECB and the European Stability Mechanism (ESM). Unfortunately, though, the ESM can’t take the heat. And it’s pretty much because Germany says so: The German Constitutional Court just ruled that fallback ECB anti-deflationary weapon is illegal.
Outright Monetary Transactions (OMTs), the tool pledged by the central bank to backstop euro-zone members, violate “the prohibition of monetary financing of the budget.” OMTs have not been employed, but it was a prerequisite to establishing the stability mechanism (which was what restored confidence in the euro zone).
The European Court of Justice now must deliver the final verdict on the German court’s ruling. Â It can either side with or against the decision. Either way, the result is bound to be worrisome.
If the ECJ sides against the German ruling, and the ECB ignores it, too, then the ECB is likely put on a collision course with Germany, which will threaten the future of a fiscal union.
If the European court sides with the GCC, then the central bank is very likely crippled. That probably means revising the OMT framework and thereby threatening the efficacy, or even the existence, of the stabilizing mechanism. Back to square one.
The hope with all the anti-deflation rhetoric is that sentiment won’t deteriorate and a eurozone-wide recovery will remain the consensus assumption. Unfortunately, I think there is too much outside the control of euro-zone policymakers — the euro zone right now is simply too vulnerable to external factors.
The rhetoric surrounding deflation will go on until there is no denying it anymore. I suspect that will come later this year. Any downturn in global risk appetite that drags down global markets will only hasten the arrival of deflationary pressures on the euro zone.
The time bomb is ticking.
Best
JR
