Dawn of Deflation in Germany?

As pricing power collapses, the country's companies are suffering

Volker Lutz has run a small store selling household appliances in the north German city of Bremen for more than two decades. But on May 31, he will close up shop for the last time, a victim of falling prices, cutthroat competition, and sluggish consumer demand. "I can't make a decent return in this environment," complains Lutz, 55. "I've kept prices and margins to a minimum, but still people aren't spending."

Lutz isn't alone. Businesses across Germany, Europe's biggest economy, are increasingly being squeezed by lower prices. Last month, the consumer price index rose at an annual rate of 0.7%, down from 1.2% in April, 2002, and 2.7% the April before that. For all of 2002, the consumer price index rose just under 1%, but in many sectors of the economy prices had been falling. The cost of durable consumer goods such as dishwashers and refrigerators, for example, fell at an annualized rate of 1.2% in May. Nondurables slipped 0.3%. Clothing and DVD players are now cheaper than they were last summer. A decade ago, products such as these would have been made in Germany, but now most are imported from low-cost locales like Eastern Europe or China. Automobile prices have slipped too. So have air fares, thanks to a weak economy and depressed demand. Prices have also come under pressure because of deregulation and the resulting competition from successful discounters such as Ryanair. "Two years ago, everyone thought the low fare airlines wouldn't survive," says Ryanair CEO Michael O'Leary.

These early indications of price fragility are sparking fears that the country's overall inflation rate could soon turn negative. Not all economists are convinced that will transpire, but some are raising an alarm, saying Germany risks the same fate as Japan if it waits too long to act decisively by deregulating labor markets, slashing surging social security costs, and making other much-needed structural reforms. Some also fret that deflation could spread to other members of the European Union. Holger Fahrinkrug, an economist at UBS Warburg in Frankfurt, expects overall prices in Germany to begin falling as soon as early next year. "That doesn't necessarily mean Germany will become deflationary," says Fahrinkrug. "But given its structural problems there is a risk."

What's clear is that, at a minimum, German companies are finding it harder than ever to maintain margins and profits. That collapse in pricing power is the product of many recent failings in the once-strong economy. High wages and rigid labor rules have hurt productivity, eroded earnings, and made companies reluctant to hire. With unemployment creeping up and taxes rising, overall personal income is declining. Consumers don't just desire cheaper goods -- these days they need them to make ends meet.

Of course, lower prices aren't necessarily a bad thing. But with Germany's economy mired in recession, the worry is that the negative cycle will become permanent: Companies that cannot raise prices shed more workers, and laid-off workers only spend if prices drop further. That kind of deflationary spiral is what worries economists and corporate executives. Deutsche Bank Chief Executive Josef Ackermann warns that Germany is already being looked on by many foreign investors as the next Japan. "We're in a very difficult situation," he says.

Analysts predict that some of Germany's largest enterprises -- such as Deutsche Telekom and the Allianz insurance group -- could be hit hard if deflation takes hold. Telekom will be hurt because it is so heavily indebted. As the value of cash increases, so does the relative size of Telekom's debt burden. Allianz's investment revenues could slide as interest rates on government and corporate bonds decline. That will pinch profit margins because insurers must pay out guaranteed minimum returns to long-term savers. Banks would also take a pounding as demand for new loans dries up and an increasing number of old loans go bad. "If we do slip into deflation -- and that is still a big if -- our nonperforming loans would rocket," says a board member from one Dutch bank.

There is already evidence that falling prices, if not outright deflation, are spilling over into the rest of the euro zone. French and Italian producer prices fell for the first time in five months in April, suggesting inflation in both of these countries is decelerating. Experts say the real carnage would come in the retail sector, especially at medium-size companies that can't exploit economies of scale to reduce costs and don't have a strong market position. At the same time, deflation would produce winners among companies that are well versed in reducing expenses, such as German discounter Aldi Group or Swedish furniture giant Ikea International.

With the retail sector as the trip wire, German executives would be well advised to prepare for the possibility of widespread deflation -- remote as that may seem now. Those that don't rein in expenses, pay down debt, and raise cash may wind up in the same boat as Herr Lutz -- contemplating early retirement.

By David Fairlamb in Frankfurt, with Carol Matlack in Paris and Kerry Capell in London

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