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Germany: IMF Warns Of Heading Toward Deflation

The International Monetary Fund (IMF) warned last week that the euro-zone's biggest economy, Germany, could be heading for deflation. There have also been fears about deflation in the United States, RFE/RL reports. But why should anyone worry about falling prices?

Prague, 27 May 2003 (RFE/RL) -- No wonder they call it the "dismal science."

Falling prices might sound like good news to ordinary people. But economists warn that deflation can be extremely harmful to an economy -- and harder to beat than inflation.

"Economists tend to think that inflation is in some sense the lubrication in an economy," says Mark Taylor, an economics expert at Warwick University in the United Kingdom.

"You can adjust relative prices in real terms relatively easily through the moderate rate of inflation in the economy. Once you fall below 2, 3 percent -- certainly when you get zero or negative inflation -- then that becomes detrimental to the functioning of the economy," he says.

That's why alarm bells were ringing in Germany last week when figures for May showed annual inflation at its lowest level in nearly four years -- just 0.7 percent. A survey out yesterday, by the Munich-based Ifo Institute for Economic Research, which showed rising business confidence soothed some of those fears. But deflation is still a worrying prospect, for several reasons.

One is that it can put a brake on economic growth. Let's say wages do not fall in line with prices. That puts a strain on firms, which are already struggling with the consequences of a strong euro.

"That's bad if the economy is not booming," says Taylor, "because it means that the real costs to producers, to manufacturers, will rise. So it means that they will be forced to lay off labor, perhaps, as labor becomes more expensive to them. So that could then generate further falls in consumer confidence, consumer expenditure, which will generate perhaps further deflation. So you get stuck in this deflationary spiral, as it were."

So deflation can deter people from spending. Alan Marin, an expert on the European economy at the London School of Economics, says, "If people see that prices are beginning to fall, then it pays to hold off further from buying, say, durable goods, because that means that prices will be lower still in the future. So it can intensify a slump if people delay purchases to try and take advantage of falling prices."

Deflation can also be harder to beat than inflation, in part because it's a less familiar problem. Japan is currently struggling with deflation, but the rest of the industrialized world hasn't seen it in 50 years.

There are other reasons, too. One way to fight deflation is for central banks to lower interest rates. But what if rates get cut to zero?

Governments can try to spend their way out of the problem. But Germany can't do that because of the strict rules on European monetary union. Berlin is already heading over the budget deficit limit.

And it can't lower rates, because monetary policy is dictated by the European Central Bank (ECB).

Taylor says this throws into question the wisdom of having a common monetary policy across an area with different levels of economic activity. And he says there's not much Germany can realistically do to combat deflation.

"Basically it can only really increase pressure at the ECB level. If it's hampered, as you say -- it's at the upper limit of its fiscal policy budget deficit from the growth pact and it can't move interest rates -- then at the macroeconomic level its choices are severely constrained, I'm afraid," Taylor says.

Marin says another option is for the EU to allow Germany to breach the budget deficit limit without facing any penalties.

But relief could come sooner, in the form of a rate cut by the European Central Bank. Some analysts expect a rate cut when the bank meets next week.