IT'S ONLY GERMANY...

Think-tank warns on eurozone deflation (Ed Crooks, May 21 2003, Financial Times)

The eurozone's economy is likely to fall into deflation if the euro returns to its equivalent peak levels of the mid-1990s, according to one of Britain's most respected economic forecasters.

Simulations by the National Institute of Economic and Social Research, prepared for European central banks and finance ministries that use them for comparison with their own models, suggest that if the euro rises by about another 20 per cent, there is a roughly two in three chance that it will push average inflation for the eurozone below zero. [...]

Ray Barrell of the NIESR said: "At the moment, the chances of inflation falling below zero in the eurozone as a whole are quite low: perhaps 5 per cent. But if the euro were to rise to those 1995 peaks, then the chance of deflation in the eurozone is better than even."

It would also take up to 1.8 per cent off the eurozone's gross domestic product, he said, threatening to push it into recession, or at least a further period of slow growth.

A rise in the euro against the dollar is also likely to be bad for global growth as a whole, because it hurts the eurozone more than it benefits the US. "Because the eurozone economy is nowhere near as flexible as the US, eurozone output will fall more than US output rises," Mr Barrell said.

The impact would depend on how the euro moved against other currencies apart from the dollar: if other currencies are also rising, the effect would be less.

Most economists do not currently see deflation as an imminent threat to the eurozone.

"I don't think it is just around the corner, except in Germany," said Robert Barrie of Credit Suisse First Boston.

If the eurozone economies are integrated to any significant degree and the predominant economy within the eurozone--Germany's--falls into deflation, how do the others avoid its effects?

MORE:
-Deflation Primer (Financial Times)
-This Deflation Is Not a Monetary Phenomenon (Stephen Roach, May 21, 2003, Morgan Stanley)

Don't listen to the monetarists. They would lead you to believe that both inflation and its diabolical mutation--deflation--are simply monetary phenomena. As long as central banks have control over the printing press, goes the logic, rest assured--they will never abdicate control over the aggregate price level. I would argue, instead, that the current perils of deflation have little or nothing to do with your favorite monetary aggregate. Today's strain of deflation risk is first and foremost a story of the cyclical imbalances and structural flaws in real economies--problems that are far from amenable to the so-called monetary fix. That's especially the case in the United States, where the deflation debate now rages.

As most of the world has finally caught on to the risk of deflation, it's worth reviewing why. It's not just that America's price statistics are now flashing ominous warning signs. It's that the analytical underpinnings to the case for deflation suggest there could well be more to come. As I see it, there are three powerful forces at work... [...]

Lest I be accused of fixating on the image in the rear-view mirror, it’s the prognosis of the future that I find so disconcerting. The confluence of forces that have given rise to this outcome--the business cycle, the bubble, and globalization--remains very much in place. Barring the immaculate conception of policy traction in a post-bubble US economy, the case for a prompt and sustained resurgence to a vigorous aggregate demand path remains a weak one, in my view. Meanwhile, an increasingly self-absorbed world seems to be flirting with the perils of competitive currency devaluation as a means to temper deflationary pressures. If anything, that makes the future even more worrisome. Deflation risks should be viewed as
a wake-up call for a dysfunctional global economy. Global rebalancing is the only way out. Monetarism is not the answer.

Posted by Orrin Judd at May 22, 2003 12:05 PM