Germany: Deflation's Deepening Shadow

The soaring euro, which acts like a tightening of monetary policy, is also tightening the noose around Germany, where the risk of deflation is rising. That makes deflation a worry for Germany's neighbors in the euro zone as well.

Because of the currency's surge, the European Central Bank, which was already behind the curve in preventing another regional recession, is now further behind. Using the ECB's own model, economists at Morgan Stanley (MWD ) estimate that the ECB will have to cut its policy rate, now at 2.5%, by one percentage point just to offset the downward pressure on both growth and inflation caused by the rising euro. Since the analysis in early May, the euro has risen further, and the new ambiguity in U.S. dollar policy could push the currency even higher.

Germany, about a third of the euro zone's economy, will suffer disproportionately. Real gross domestic product posted a surprise drop in the first quarter after a small dip in the fourth quarter, essentially putting the economy in recession. The second quarter also looks bleak.

The region's loss of competitiveness, due to the stronger euro, will be severe in Germany. Despite the currency's sizable depreciation in the late 1990s, the euro zone failed to increase its market share vs. competing nations, based on an analysis by J.P. Morgan Chase (JPM ) Co. That failure implies a loss of competitiveness related to the region's high and rigid labor costs. And Germany is the area's highest-cost producer.

An Apr. 30 report from the International Monetary Fund concludes that "deflationary forces are at work in Germany." Indeed, weak domestic demand is holding growth below potential for a third year. Bankruptcies are near a record. And core inflation, excluding energy and food, is already less than 1%. With core euro-zone inflation below 2% and set to fall, the German rate could slip below zero by yearend. The chief danger: Germany's teetering banks. As in Japan, deflation would make debt more onerous to repay and drive up nonperforming loans.

By James C. Cooper & Kathleen Madigan

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