International Monetary Fund: Inflation Danger is Why Europe Not Out Of Woods Yet

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An improvement in growth for the European Union and a renewed willingness to buy government debt in the distressed periphery has us clapping our hands in admiration at the turnaround the region has achieved in just the last 12 to 18 months.

The rot was stopped in the summer of 2012 around the time of EU President of the European Central Bank Mario Draghi’s statement that the bank would do whatever it took to keep the euro together and fund those states that were all but closed off to international credit marks at anything like a sustainable borrowing rate.

But according to an FT article, even the International Monetary Fund does not believe Europe is out the woods and, put simply, is just one negative shock away from outright deflation.

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What exactly is the problem?

The problem is that consumption is so low, that at 0.8%, inflation is dangerously close to becoming deflation.

As the FT points out, low inflation has coincided with weak demand. In the fourth quarter of last year, eurozone real demand was 5% below levels in the first quarter of 2008. In Spain, real demand fell 16%; in Italy, it fell 12%, and even in Germany, real demand stagnated from the second quarter of 2011.

The failure to offset this has made recovery of crisis-hit economies more difficult, lowered investment and created long-term unemployment.

Does It Matter?

Not so long ago, 0.8% inflation would have been considered a success as countries battled to bring inflation down from 6-8% or more. But for countries looking to restore competitiveness, low inflation is costly. If inflation in the core economies like Germany is low, it has to be negative in the recovering economies; falling prices raise the burden of public and private debt.

The FT postulates that if real inflation was on average 2%, core economies would be 3% and recovering ones 1%, the economy would then likely be growing faster and able to internally adjust more quickly.

Quantitative easing and purchasing government bonds would help, but the main beneficiaries would likely be the periphery economies and that would promote hysteria in Germany where austerity is seen as the solution. The FT makes the point that part of the problem is the ECB seeing its role as stabilizing not the European economy, but the German one, and that ultimately it will only take steps that are in Germany’s best interest.

As a result, the European economy has deep flaws still at its heart and low inflation is one example of how fragile the system remains. Let’s hope an energy shock from the east is not what precipitates another crisis – we had all rather gotten used to the sense all that was behind us.

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