Europe risks entering a deflationary spiral, from which it would be very hard to escape. The thought that goods and services may be cheaper over time can have a crippling effect on an economy – one only needs to look at the experience of Japan over the past 20 years.
Businesses and individuals alike postpone spending decisions, believing goods and services will cost less in the future. Firms are forced to cut prices to attract customers. They may also cut or freeze wages in a bid to relieve margin pressure, further depressing domestic consumption.
Eurozone inflation fell into negative territory in December, for the first time in six years, and there are risks that this situation could persist. Draghi has used a range of tools in the ECB’s attempt to encourage activity, from ultra-low interest rates to its latest targeted long-term refinancing operations. His next move looks likely to be quantitative easing (QE). The hope is that the purchase of government bonds and other debt instruments will pour extra money into the economy to stimulate growth and remove the deflation threat.
Whether such unconventional measures will be successful remains an open question. The US Federal Reserve recently ended its bond purchase programme, which began in November 2008. At the very least, US QE probably held down interest rates and boosted asset prices, with the S&P 500 returning 160 per cent during the period. Partly as a result, the US economy is likely to underpin global activity this year.
But with Eurozone interest rates already at exceptionally low levels, not to mention the fact that the ECB looks set to begin QE when the UK and US are both contemplating interest rate tightening, Draghi realises that QE alone will not solve the continent’s problems. He is also pushing for the implementation of structural reforms – including tough decisions on welfare and the freeing up of labour markets – and growth-friendly fiscal policies.
Even if these politically sensitive issues are addressed, this is still no guarantee that the region’s recovery will become more sustained, and that the deflation trap will be avoided. A big determinant will be the strength of growth elsewhere in the world. While the UK and US appear to be on track, some other countries with economic and other ties to the Eurozone (such as Russia) are on the verge of recession.
At present, suspicious minds both in and outside the Eurozone are questioning whether Draghi and the currency bloc’s political elite can rescue the region from deflation. In the end – to reference other Elvis hits – the continent could end up in the Heartbreak Hotel; or if policymakers are sufficiently all shook up and act, the Eurozone could stage a more convincing recovery.