January 5th, 2014 6:16 pm | by John Jansen |

The WSJ is running an article on deflation in Europe. It notes that at the present time only the tiny triumvirate of Cyprus, Latvia and Greece are actually experiencing falling prices. But the story notes that the ECB target is 2 percent and in spite of massive injections of liquidity inflation is currently running at about 1 percent. The author notes the Japanese experience and the deleterious effect of deflation on growth.

Via the WSJ:

The Outlook Europe Faces Specter of Deflation Fears Grow of Falling Prices and the Economic Destruction They Cause

Stephen Fidler By

Jan. 5, 2014 5:01 p.m. ET

Relatively few people alive today in the West have experienced deflation, but for Europeans, that may be changing.

Anxieties are rising in the euro zone that deflation—the phenomenon of persistent falling prices across the economy that blighted the lives of millions in the 1930s—may be starting to take root as it did in Japan in the mid-1990s. “Deflation: the hidden threat,” ran a headline emblazoned across a December research note by economists at HSBC.

At last count, prices are falling only in Latvia, Greece and Cyprus. And most forecasters, including those at HSBC, see low inflation as more likely than deflation on average in the euro zone.

But inflation is stubbornly low, under 1% on average across the 18-nation bloc, despite the money that the European Central Bank has been pumping into the economy with the aim of spurring investment and growth, actions that often push up inflation. That is way under the ECB target of “below, but close to 2%,” and, if the average is below 1%, more economies using the euro are at risk of deflation.

Why worry? If economies cope with inflation, why not with deflation? For centuries until World War II, capitalist economies experienced periods of severe deflation interspersed with spells of inflation and continued on a path of long-term growth.

But historical experience is one reason policy makers don’t want a return to the 19th century. Germany’s hyperinflation in the 1920s was followed in the 1930s by deflation that created widespread economic hardship in that country as prices fell 23%.

Today, German policy makers aren’t too worried. A paper published in December by the Bundesbank, Germany’s central bank, proclaims, “No deflation in sight.” In Germany, that may be true: The latest figure for November shows annual inflation of 1.6%, the third highest in the euro zone.

But others are less sanguine. Jean Pisani-Ferry, head of France’s economic-policy planning council, argues in an article for Project Syndicate, “It’s past time to recognize the deflation danger facing Europe.”

With the economy operating below capacity and unemployment in the bloc averaging above 12%, prospects for serious blows to growth elsewhere in the world and subdued commodity prices, Mr. Pisani-Ferry sees a real risk of falling prices.

Even the Bundesbank concedes that if deflation sets in, growth is almost impossible. People and companies hold off from spending, believing that prices will fall further, causing demand for goods and services to fall.

Wages and salaries hold up initially, but slumping corporate profits eventually force companies to cut output and wages, hold off investment and lay off workers. Falling income and rising unemployment pushes demand lower, setting off a self-reinforcing downward economic spiral. Banks, meanwhile, are enfeebled as losses on loan portfolios grow.

If this weren’t enough, deflation throws up further obstacles to growth. Real interest rates—measured by nominal interest rates minus expected inflation—rise, increasing burdens on borrowers and would-be entrepreneurs.

Central banks can respond by lowering their benchmark interest rates. But the ECB’s refinancing rate is already just 0.25%, leaving little room to cut further. And while negative interest rates—charging banks to keep money at the ECB—are theoretically possible, there is a limit to their effectiveness. Banks are likely to start charging customers for deposits, encouraging depositors to withdraw money and hoard it.

For borrowers, deflation is a double whammy. In addition to increasing the real costs of servicing debts, as deflation shrinks the economy, it also increases the burden represented by existing debt. The nominal value of debts doesn’t change as incomes diminish, so a greater share of national (or personal or corporate) income must be devoted to debt repayment.

This latter phenomenon is, on the face of it, a zero-sum game. Creditors benefit, and debtors lose out. But the problem for the euro zone is that the debtors are concentrated in the slowest-growing, deflation-prone countries, like Greece, Spain, Portugal and Italy, to the south.

Those already suffering most of the pain will be asked to bear more. Or they won’t be able or willing to bear more—and will default on their debts. That would have severe knock-on effects for domestic banks and other creditors, threatening further hardship. There are plenty of reasons to worry.