Denial is no longer an option.

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Draghi's Deflation Nightmare

Mark Gilbert is a Bloomberg View columnist and writes editorials on economics, finance and politics. He was London bureau chief for Bloomberg News and is the author of “Complicit: How Greed and Collusion Made the Credit Crisis Unstoppable.”
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European Central Bank President Mario Draghi hoped never to see this moment: Consumer prices in the euro region have dropped by 0.2 percent, according to December figures just published:

Deflation -- a sustained period of falling prices that discourages consumers from spending and businesses from investing -- threatens to worsen the euro bloc's economic woes. Draghi spent most of 2014 in denial about the risk, claiming to be upbeat about the ECB's chances of meeting its 2 percent inflation target over the medium term. Finally, last week, he admitted that the mandate won't be fulfilled.

Europe's QE Quandary

It's taken Draghi far longer than it should have to accept that reality. He now faces war on two fronts, as Europe's worsening economy meets the looming political crisis in Greece that endangers the euro itself.

To be sure, the collapse in oil prices is having a big effect on inflation indexes; core inflation excluding energy and food prices actually rose 0.8 percent last month. With oil dropping below $50 a barrel this week, headline inflation figures in the euro region are also likely to be negative for the next few months.

Expectations are high that, at the next ECB meeting in two weeks, Draghi will finally announce a program to buy government debt to channel cash into the economy. In theory, such quantitative easing should free up capital to boost bank lending to businesses. However, economic theory suggests that deflation inhibits capital spending, because companies become convinced that such investment will become ever cheaper. With deflation already in place, QE may come too late to rescue the European economy.

No wonder investors are driving government bond yields across Europe to record lows. The cost of 30-year money in Germany slumped to a record 1.12 percent today, half what it was in the middle of last year and down from as high as 4 percent four years ago. Because there's scant prospect that inflation will erode bond returns in the coming years, investors are willing to accept skimpier returns for the perceived safety of stashing cash in German government debt.

That upcoming ECB gathering, moreover, will occur three days before Greeks elect a new government. The current poll leader, Alexis Tsipras of the Syriza party, says he wants to renegotiate Greece's debt burdens. Yet the German press suggests Chancellor Angela Merkel would rather see Greece exit the euro than relax the austerity conditions of its bailout. "Systemically, they are not relevant any more, the Greek people, so I’m not afraid for any other country,'' Michael Fuchs, a senior lawmaker in Merkel's party, told Boomberg Television today.

So Draghi may find himself buying euro zone government debt at a time when one member is effectively threatening to leave the common currency, and its peers seem unperturbed at the prospect. Trying to revive European growth at the same time as the euro's future is at risk? Mario will need super powers to pull that off.   

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Mark Gilbert at magilbert@bloomberg.net

To contact the editor on this story:
Mary Duenwald at mduenwald@bloomberg.net