Europe’s economic crisis looks set to lurch further into the mire it currently finds itself in. The European Central Bank’s (ECB) President Mario Draghi suggested this week the bank remains committed to hitting its 2% inflation target.
But the fight against deflation is not a winnable war. It’s not too dissimilar from the fight against terrorism. You can bomb deflation through the expansion of money supply forever. But you’ll never overcome it unless you remove the root cause.
We’ll look at why Europe’s deflationary problem is here to stay shortly. But first, here’s what Draghi had to say on the situation facing Europe:
‘If we decide that the current trajectory of our policy is not sufficient to achieve that objective, we will do what we must to raise inflation as quickly as possible. In making our assessment of the risks to price stability, we will not ignore the fact that inflation has already been low for some time.
‘If we conclude that the balance of risks to our medium-term price stability objective is skewed to the downside, we will act by using all the instruments available within our mandate. In particular, we consider the asset-purchase program to be a powerful and flexible instrument, as it can be adjusted in terms of size, composition or duration to achieve a more expansionary policy stance.’
No need to read between any lines here. Draghi’s pulling no punches. He’s more or less guaranteed the Eurozone is heading for more monetary stimulus, and fast. Why? Core inflation, at just 0.1%, remains well below the bank’s 2% target.
The next ECB meeting, scheduled for 3 December, will be key. That’ll open the door for a likely announcement of a fresh round of stimulus.
The ECB fears doing nothing instead will raise the likelihood of deflation. Which is exactly what would happen. And as long as the Eurozone economy remains in its current slump, low inflation will persist.
Peter Praet, chief economist at the ECB, reckons the bank risks its credibility if it doesn’t take action in addressing this problem. He’s wrong on that account. The ECB doesn’t have much credibility left. Few central banks do anymore.
After a decade of monetary stimulus, economies still struggle with low inflation. If these stimulus measures worked, that wouldn’t be the case. But they don’t. All they do is kick the can down the road. How long this ruse can last is anyone’s guess.
Why central banks hate deflation
In any case, the one thing the ECB won’t do is let deflation set in. Or at least it’ll do everything in its power to prevent it from doing so.
Deflation is like the bogeyman for central banks. There’s nothing they hate more. We have a war on terrorism, a war on drugs. But the war on deflation has been just as forceful.
As deflation spreads, it increases the risk of what we might term delayed consumption. In other words, consumers cut back on spending. Why? Because deflation leads to lower prices as the value of money goes up. If consumers expect prices to drop in the future, they’ll delay purchasing goods. Anytime consumption declines, it hurts economic growth as well.
On top of this, deflation can increase the real burden of debts. As mentioned, deflation increases the real value of money. The outcome of this is that consumers and businesses often find their purchasing power reduced.
Another effect is that low deflation may also lead to higher unemployment. Again, in times of deflation, real wages actually rise. In a low growth economy, that may lead to further job losses. Europe’s unemployment is already bad enough. It has the highest unemployment rates among the developed world, at 10.8%. That’s almost double Australia’s 5.9% unemployment rate. If deflation sets in, the labour market in Europe could deteriorate even further.
So you can see the dilemma facing the ECB.
To stimulate the European economy, the ECB will try one of two things.
It could inject more money as part of its quantitative easing program. Already this year it’s pumped €1.1 trillion into the battered economy, to little avail. Yet more QE remains the likeliest course of action for the ECB. If only because it tends to work for a couple of months.
The other option available to the bank is to lower interest rates. The Eurozone interest rate is set at 0.05%. If the ECB cut rates by 0.25%, it’d send the cash rate into negative territory.
Negative interest rates (NIRP) are as ridiculous as they sound. Depositors get charged for storing money in banks. If you paid fees on your savings, would you start walking around with dollar notes in your pockets? I know I would. But that’s the reality facing Europe.
As an aside, it probably explains why there’s been recent talk of banning cash altogether. People would have no choice but to put up with NIRP, and the effects it’d have on their savings. They’d have no recourse for taking cash out of a bank anymore.
Maybe the ECB will use both instruments available to it. You never know. Desperate times call for desperate measures. And, outside the US and Japan, there are few central banks as desperate as the ECB these days.
Yet as Japan shows, deflation can be difficult to overcome once it sets in. Japan’s struggled with low inflation for decades. The economy has barely grown in that period. Every time it tries to stimulate, new money perks the economy up a bit, and then flops. Why? Because inflationary policies should support growth, not supplant it. Without the capacity to organically grow an economy, monetary stimulus is nothing but a quick fix.
Why the ECB can’t fix low inflation
Unfortunately for the likes of Europe and Japan, their current situation might be as good as it gets. The days of high, persistent growth could be over, never to return again.
It all has to do with demography.
Japan hasn’t fixed its deflationary problem because it’s peaked demographically. Its most important consumer base, the 18–39 year olds, is getting smaller every generation. The same is true for Europe. Both have an inverted population pyramid. All that means is that each up and coming generation is smaller than the last. Reversing this is borderline impossible. No single nation has reversed the effects of a falling birth rate.
Sometimes the answer is as simple as that. Demography is destiny. A balanced population, where the youngest outnumber the oldest, is a potential economic dividend. Anything less than that is a ticking timebomb.
Many people struggle in figuring out why these economies are stuck with low inflation and low growth. But economies grow on the basis of one of two things: consumption or production. Production has spread out across the world. And it’s wholly dependent on demand. But there’s just not enough of the right kind of people to consume as there once was. That’s the real issue.
Sure, the global population will continue rising this century. But it’s already peaked from the perspective of birth rates. Outside of Africa, no other continent is producing enough babies to replace its current population.
In real terms, global population will continue growing. But with below replacement birth rates, we’ve already peaked as a planet. That will leave us with an ever smaller consumer base. It’s worth remembering that the age groups that matter for economic growth are the ones that buy houses, cars and other large goods.
Yet Europe, on the whole, is greying. Ever more taxpayer money will go towards caring for the elderly. And there’s an ever smaller number of younger people to consume.
As it ages, Europe’s capacity to grow its economy will diminish. The ECB can stimulate forever and a day. But the underlying effects of low inflation won’t go away. If anything, they’ll only get worse.
Don’t be surprised if Europe’s next 20 years resembles Japan’s (still) lost generation. Let that be a lesson for Australia.
Contributor, Markets and Money
PS: Markets and Money’s Phillip J. Anderson reckons interest rates will remain at record lows for years. In his brand new report, ‘Why Interest Rates Could Stay Low for the 21st Century’, Phil warns that you won’t be able to rely on your savings to fund your retirement.
Inflation, stemming from low rates, will eat into your savings. Worse still, you won’t be able to count on savings funding your retirement. The regular return on term deposits has halved in the last four years alone.
But you have options…if you choose to act now.
Phil wants to show you the best way to invest in this low interest rate environment. He’s prepared a four-step strategy that could boost your portfolio and wealth. You’ll learn exactly where to park your cash over the coming decades. And you’ll see how this could lead to incredible profits. To download the report, click here.