| Summary
Sweden's Riksbank reduced interest rates from 2 percent to 1.5 percent
June 21, drawing further attention to the steadily worsening European
economic situation. With low levels of consumer spending and investor
confidence, and high levels of unemployment and institutional angst,
Europe could be on the cusp of a deflationary crisis. This is especially
true for the core economies of France, Germany and Italy, which could
endanger neighboring states that might be performing better. Europe
already is operating with low interest rates and high levels of deficit
spending -- the traditional correctives for deflation. Europe's best
hope could lie in the appreciation of the dollar.
Analysis
The Riksbank, Sweden's central bank, reduced interest rates from 2
percent to 1.5 percent June 21, sparking discussion of a possible rate
cut at the European Central Bank. Europe, facing an economic slowdown,
already is functioning at low interest rates and high levels of deficit
spending.
This economic outlook has combined with the recent pessimistic turn in
European politics to create the possibility for a European deflationary
crisis. The only real hope could lie in the dollar, whose appreciation
might increase prices overall, especially on non-discretionary items
that would force consumers to spend more and save less.
Deflation is a systematic decline in prices that drives people to hold
on to their money and save it instead of spending it. Fueled by a
decline in consumer confidence, deflation leads to lower consumer
spending and the accumulation of stocks of unsold goods. This build-up
in goods oversaturates the market, driving down prices and confidence
even further. Businesses respond by reducing investment and laying off
workers. With increased unemployment, consumers' economic outlook
becomes all the more pessimistic. To increase demand to a level that
complements supply, businesses lower prices, which decreases economic
activity in general, again encouraging consumers to defer purchases.
Therefore, while consumers can buy more with the same amount of money,
they also have less income. This becomes a vicious cycle of deflation,
unemployment and lowered economic activity, and is difficult for a
country to escape.
The Japanese have long served as an example of the difficulties of
deflation. Their economy has been in deflation for eight years, which
has added to the almost 15 years of economic troubles of the formerly
pre-eminent Asian tiger economy. Tokyo has tried to get the economy
started again by lowering interest rates, which have been at or barely
above zero since 2001.
A similar situation seems to be on the horizon for Europe. Economic
growth has been slowing in the region for some time now. Consumer
confidence is down; a June 8 ACNielsen poll showed that French and
Italian consumers are among the most pessimistic in the world about
their countries' economic performance. In fact, seven of the 10 most
pessimistic countries in the poll are in Europe.
Consumer spending has likewise been low, especially in the run-up to and
aftermath of the recent constitutional referendums. The most recent
numbers show a continued downward trend; consumer spending on
manufactured goods in France dropped to 0.9 percent from April's 1.1
percent. Germany is not much better off; May reports showed that the
German domestic economy shrunk 0.6 percent in first quarter of 2005 in
part because of declining consumer spending.
Investor confidence has followed a similar downward trend. The European
Commission reported May 31 that its index of business confidence had
fallen to negative 11, a 21-month low. National statistics for France,
Germany and Italy all show similarly low spirits among investors. Add to
that Europe's continuing high unemployment -- German and French April
2005 unemployment levels were at 10 percent and 9.8 percent,
respectively -- and the picture looks all the more bleak.
This grim economic outlook is intensified by the already depressed
sentiment following the constitutional referendum failures in France and
the Netherlands and the paralysis over resolving the EU budget dispute.
Adding economic pressures to recent consistent institutional failures
does nothing for sentiment -- consumer, investor or otherwise.
Economic indicators imply that Europe could be on the cusp of a
deflationary crisis. The most recent inflation numbers reported by
Eurostat bear that out: Low and negative inflation numbers are the norm
across the continent.
In the face of such conditions, there are typically two primary methods
for reducing deflation: government deficit spending, and lower interest
rates to spark consumer demand. However, these options are hardly
available to the EU. Interest rates already have been down to 2 percent
for the last two years. There is not much room to go any lower.
In terms of deficit spending, core countries such as France, Germany and
Italy have been in violation of the EU Stability and Growth Pact --
which requires member countries to keep deficit spending under 3 percent
of their gross domestic product -- consistently since 2002. And most of
that spending goes toward relatively unproductive economic pursuits such
as welfare transfers, as opposed to more expansionary programs. These
countries could redirect the course of that spending to make it more
effective in generating economic activity, but that would require a
drastic philosophical change of attitude that much of Europe is
unwilling to accept. Those countries that have accepted it to some
extent are doing far better than those that have resisted it. Therefore,
the solutions to European economic problems are pretty obvious at this
point -- the problem is the political resistance.
Therefore, with already low interest rates and high levels of deficit
spending, the major European countries already have tapped out
conventional routes for decreasing deficit spending and have failed to
see positive results. Inflation is certainly higher on the European
periphery -- which will help alleviate the stress -- but Italy, Germany
and France combined account for some three-quarters of the eurozone
economy, while all of the European Union's 10 new members combined add
only about 5 percent. If deflation is to be defeated, it must be done in
Europe's core.
One hope for Europe, ironically enough, is the potential for
inflationary pressure elsewhere in the global economy -- specifically
coming from appreciation of the dollar. The dollar has risen 10.5
percent against the euro this year after bottoming out in the last half
of 2004. Since oil is priced in dollars, a higher dollar means higher
oil prices for Europe, and higher oil prices mean higher prices overall,
which could push people to spend rather than save.
For now, this pressure on largely non-discretionary spending looks to be
the top factor preventing a future deflationary crisis in Europe -- and
that does not bode well for the region, since oil prices today play a
far less significant role in overall prices than they used to. This is
evident in falling eurozone prices despite rising oil costs and a
stronger dollar. More than likely, this dependence on non-discretionary
spending to prevent deflation will lead to stagflation; furthermore,
this dependence is unlikely to fix European problems that are
structural, not cyclical. Since political reform that could fix the
structural problems is so unlikely, rising energy costs, as insufficient
as they are, remain Europe's best hope.
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