Most European central bankers weren't yet born when German inflation ran out of control and a dollar bought more than a million Reichsmarks. Yet critics are muttering that policy at the new European Central Bank still seems driven by those grainy 1923 newsreels of housewives pushing wheelbarrows of cash to buy a single loaf of bread. Some economists think this fear of inflation has blinded the ECB to an equal danger: deflation.
Technically, Europe hasn't entered deflation territory yet. Although price rises are edging close to zero in parts of the euro zone, inflation hasn't gone into negative numbers (chart). No matter: Europe's investors, central bankers, and executives are rapidly taking sides in a debate over whether full-fledged deflation is about to sweep Europe or whether the price declines of recent months are healthy. Who wins this argument could determine Europe's next step in managing the economy and setting the course of interest rates.
The two views could not be more different. Those who see deflation hovering on the horizon fear a downward spiral in prices that would depress asset values, sap consumption, and squash output. But for the optimists, price reductions are an ally of progress, a force that increases buying power and prods companies into greater efficiency.
ON THE UPSIDE. It's easy to find vocal proponents of both views. "The risks of deflation are rising," says London-based Morgan Stanley Dean Witter economist Joachim Fels. The warning signs are biggest in Germany and France, which account for more than half of the euro zone's economy. According to Morgan Stanley estimates, Europe's two largest economies dragged down prices by 0.2% in the euro zone during January, excluding volatile food and energy.
Yet optimists counter that falling prices can be interpreted another way. For one thing, they make people feel richer. Consumer confidence is soaring everywhere except in Germany, reaching an all-time high in France. Europewide, consumption grew at an annual rate of 3.4% in the fourth quarter, from 2% a year earlier. "There's nothing wrong with price declines if they're not due to a lack of demand," notes Goldman, Sachs & Co. economist Thomas Mayer. And taking a little pricing power away from manufacturers forces them to find other ways to fatten margins.
Bur even the threat of deflation puts the ECB in a bind at a time when it's eager to establish its hawkish credentials. The bank is already under pressure from politicians to slash interest rates in order to stimulate growth--especially in Germany, where slumping exports caused gross domestic product to contract by 0.4% in the fourth quarter of 1998. European governments, meanwhile, are hearing ever-louder calls from chief executives to cut taxes and loosen labor regulations. "We need to be injecting more money into the economy," says Carl Michel, chief executive of Deutsche BA, British Airways PLC's German unit.
So far, the ECB has held firm, insisting that price drops are nothing to worry about and allowing its benchmark lending rate to hold at 3% at its Mar. 4 meeting. The bank foresees "no signs of deflation in the euro area," says ECB President Wim Duisenberg. But Morgan Stanley, for one, believes that the ECB is more concerned about deflation than it is letting on and might well cut rates by 0.75% by midyear. That could boost euro zone growth to a healthy 3.2% in 2000, up from an estimated 1.9% this year, according to Morgan Stanley.
For the time being, though, the deflation debate is fueling tensions between Europe and the U.S. Federal Reserve Chairman Alan Greenspan and other top Fed officials are believed to be privately jawboning the ECB to lower interest rates. And fearing that Europe isn't doing enough to stimulate its own economy, U.S. officials such as Treasury Secretary Robert E. Rubin and State Under Secretary Stuart E. Eizenstat have been hammering at European politicians for economic reforms. "I'm growing more worried about a deflationary cycle," frets former Fed Governor Lawrence B. Lindsey.
Europe's price tumble is due in part to global trends. Falling oil prices helped slash energy costs by 4.7% in euro countries last year. Beleaguered Asian manufacturers have cut prices of exports such as electronics goods to boost their market share in Europe. That's why the price of such items as television sets and videocassette recorders fell 7.2% in France last year. On top of that, a worldwide glut in capacity is making it difficult for European manufacturers to raise their prices. A passenger car cost just 1.7% more in 1998 than the year before, with higher sales tax accounting for most of the increase.
ASIAN FALLOFF. But conditions specific to the euro zone could cause inflation to dry up entirely and even turn negative. For one thing, the single currency makes it easier for Europeans to comparison shop. That will take even more pricing power away from makers of cars and other big-ticket items. Deregulation, too, is rapidly pushing down prices in telecommunications, airlines, and energy. In Germany, the cost of phone service was 11.5% lower in February than a year ago, as dozens of startup companies assaulted Deutsche Telekom's former monopoly.
Slowing economic performance is adding to the downward pressure on prices. The problem is especially acute in Germany, where a falloff in exports because of the Asia crisis and confusion over the new Social Democratic government's policies are threatening to derail a fragile recovery. The German economy's unexpected contraction in the fourth quarter prompted Salomon Smith Barney to ratchet down its forecast for Germany's growth this year to just 1%.
As they deal with these price drops. European executives see both the good and the bad. The price of mobile-phone services in Germany fell by 21.5% in the 12 months ended in February. Yet business boomed because lower prices attracted more customers. Stable prices attract automobile buyers too. "I am not afraid of a deflation scenario," says Dieter Zetsche, a management board member at DaimlerChrysler. "I am happy with low inflation."
But some managers shudder at even the possibility that inflation could dip into the negative zone. Deutsche BA's Michel warns that falling prices and official inaction on economic reform could be "a quite lethal combination." If he is right, the result could turn out to be as scary as those prewar newsreels.