The upcoming deflation and the European Central Bank response By Dr. Bobby Srinivasan and Dr. Sudhakar Balachandran

We will continue the conversation between Joe and Swami to bring out this important issue which will have far reaching consequences in the near future. The conversation follows.

Joe       : Swami, How are you? Can you come on the Skype? I have a set of questions for you

Swami: Sure. After a while

Joe        : Swami, I have read the news about negative interest in the euro zone, in the press here. I believe that the euro zone has lowered the interest rate by 15 basis points and made the fixed deposit rate negative. Does that mean that if I deposit money in the euro in a bank I have to pay interest?

Swami  : Sure you do. Looks strange isn’t it. Mario Draghi, the European Central Bank President is in a quandary. The euro zone economy is in a deep mess. High rates of unemployment along with extremely low rate of economic growth. Banks are refusing to lend to small and medium enterprises. So he is pumping in 400 bln euro to the banks to facilitate lending

Joe        : What happens if you push the interest rate down?

Swami  : I don’t know that. But, I know what Mario Draghi has in his mind. By lowering interest rates he expects that the value of Euro will drop from its present levels which will help in exports. When he announced his policy, the currency market pushed the euro from 1.3650 to 1.3502 but is now recovered back to 1.3570. Of course he is also expecting job growth

Joe        : Are you saying that this strategy is not working?

Swami  : No we need to wait. That is what Draghi’s also says. If this doesn’t work, he plans to do quantitative easing like what your country did

Joe        : What else can Mario Draghi do?

Swami  : The fact is that the value of an internationally traded currency is in the hands of the various types of investors namely traders, hedgers, speculators and arbitrageurs. The speculators normally trade millions of contracts in Euro all over the world both through the futures, options and OTC markets. They are an extremely powerful bunch of people especially the hedge funds. Also countries like China who have large amounts of dollars also are diversifying into euro by buying the currency creating an artificial demand

Joe        : Are you saying that the euro zone deflation is inevitable?

Swami  : I am not saying that but given the trend it is possible. You look at the facts. The current inflation rate is 0.5 percent. Euro zone wants it at 2 percent. From Jan 2014 to till date, the growth rate is 0.7 percent. From Q1 2008 – Q4 2013, the nominal GDP growth rate is 4 percent. There is stagnation and very weak recovery. Also during the last 6 years excluding energy, food, alcohol, tobacco the inflation averaged around 1.3 percent.

Joe        : OK. Now assuming that the euro zone dips into deflation, how does the global scenario pan out?

Swami  : Not great. In the US, the Q1 2014 growth rate is 0.1 percent. Japan’s growth rate continues to be close to zero. China is also slowing down. There is also another scary scenario. There is a sub-prime crisis building up in China. If the bubble does burst, we will see the global financial system go berserk with major bank failures and its contagion effect.

Joe        : Tell me if you are Mario Draghi, what will you do

Swami  : I will expand the balance sheet of ECB. Provide liquidity by buying assets until I feel I have controlled the deflation. You see between inflation and deflation I will prefer inflation any day. In deflation, jobs disappear investment stops and people loose confidence. In inflation, people are upset about prices but jobs and investments continue to grow

Joe        : Thanks Swami. You always helped me to understand the economic issues better. I will call you again as to why all of a sudden all things are going wrong. You see gold dropping from $ 1900 to $ 1200 an ounce. I know it is also part of the deflation picture.

Swami  : Talk to you later. Bye for now.

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