The Zombification of Europe: The Perils of Deflation

Economists like to use the term "equilibrium" to describe an economic system that has a harmonious relationship between all its moving parts.

It is a state where economic forces such as supply and demand are balanced and everything is constant or perfect.

But economics is a branch of human knowledge that is similar to the behaviour it studies: it is partial, flawed and contradictory.

Even so, there are two states of affairs that are polar opposites that economists agree societies must avoid: hyperinflation and deflation.

Hyperinflation is where the connection between wages and prices becomes volatile and erratic, as happened to Britain in the 1970s when wages and inflation leapfrogged each other. This harmed productivity and competitiveness.

By contrast, deflation is the phenomenon where wages and prices do not increase but fall sharply.

Japan experienced this in the 1990s during the so-called "lost decade" where a catastrophic fall in demand, consumption and spending brought a permanent stagnation to a once buoyant economy.

There are signs this is happening to the eurozone and it has worried policymakers at the European Central Bank (ECB).

The deflation danger prompted the ECB to take radical action and it cut the interest rate on the main refinancing operations of the Eurosystem to 0.25% from 0.50%.

Fears that deflation is beginning to become entrenched in the eurozone were reinforced with the news that prices fell in Spain.

The Spanish consumer price index fell by 0.1% in October on an annual basis, according the National Statistics Institute.

Freezing Conditions

Data from the eurozone has not been healthy of late.

Markit's eurozone composite Purchasing Managers' Index (PMI) of activity in the manufacturing and services sectors slipped to 51.9 in October from 52.2 in September.

And the European Commission has forecast that eurozone unemployment would remain near its record high of 12.2% for the next two years amid sluggish economic growth.

Preliminary data from the eurozone's statistics office showed that inflation unexpectedly dropped to 0.7% year-on-year in October - the lowest for nearly four years.

These developments prompted the ECB executive board member Benoit Coeure to say that the ECB could lower interest rates further and provide the banking system with more liquidity to stem the tide of deflation.

He argued that monetary policy had not lost its power to affect change in the eurozone.

"We can still cut interest rates if needed, and as we said clearly we can provide liquidity to the eurozone financial system if needed to ensure they don't have problems refinancing," Coeure said.

"All that's possible, but what counts is that the banks transmit the decrease in the cost of refinancing to the economy," Coeure added.

Inflation Hawk Justifies Low Interest Rates

Even ECB governing board member Jens Weidmann, an inflation hawk, said that the ECB's accommodative monetary policy was justified in the current circumstances.

Speaking at a banking conference in Frankfurt, Weidmann said that the impact of low interest rates was reduced over time while risks increased and cautioned that acting repeatedly to deal with the short term carries risks for long-term stability.

"Even if an expansive monetary policy is justified based on the outlook for prices, we should not avert our eyes from the many challenges connected with a low interest rate environment," Weidmann, who also head the German Bundesbank, said.

He ascribed low inflation levels in peripheral countries largely to necessary adjustment process rather than a self-reinforcing deflation spiral.

He argued there would always be phases where interest rates were too high or too low for a particular region of the eurozone. It was not just the responsibility of the ECB to ensure a stable single currency, he stressed.

"In a single monetary policy, other policy areas must tackle the differences between countries should these become a problem," he said. "A country could for example, in the case of an overheating economy, react by speeding up consolidation of public finances."

Prospects of Beating Deflation?

Mario Draghi, as president of the European Central Bank, is responsible for the health of the euro which is underpinned by a fractured and politically dysfunctional monetary union.

The ECB's role in the European Union is contradictory and confused and even though Draghi promised in July 2012 "to do whatever" it took to save the euro, time may be running out.

His announcement of forward guidance in July 2013 was a decisive intervention in a crisis situation.

However, interest rates that are kept low by the ECB an only work for so long.

Tragically, the problems in Europe are beyond the power of one central banker to resolve and require courageous political decisions from leaders.

Time might be running out for policymakers to avoid deflation and put the eurozone on an economic footing that does not involve long-term decline and stagnation.