Guest post by Kris Sayce from Money Morning Australia
There’s good news for Europe.
It’s just what the people there need.
We just hope they get to enjoy it.
But they probably won’t.
Because while it may be good for the people of Europe, it’s bad for Europe’s powerful elite…
Bloomberg reports on this ‘good news’:
‘Euro-area factories cut prices in September by the most in more than a year and German manufacturing shrank, underlining the mounting challenge facing Mario Draghi.
‘The European Central Bank president is on a mission to avert deflation as the euro region’s economic landscape deteriorates. Purchasing Managers’ Indexes from Markit Economics showed manufacturing activity also contracted in France, Austria and Greece, with a gauge for the 18-nation region pointing to almost stagnant output.’
We’ll translate that for you in case you don’t get it. Europe’s factories are cutting prices. They hope to encourage businesses and consumers to buy their products.
It’s price deflation. For those who live in Europe, where the jobless rate is in double-digit percentage figures, price deflation is good news.
Who wouldn’t rather pay less for something, instead of more?
But as we say, what’s good for consumers isn’t good for the elites. That’s why European Central Bank president Mario Draghi is doing all he can to make sure prices don’t fall.
Don’t hate falling prices
To everyone apart from a mainstream economist and the lackies that follow them, falling prices is good news.
If prices fall, it makes things cheaper. That’s what you want when wages are falling and the jobless rate is high.
Falling prices would be just the spur Europe’s crumbling economy needs. Sure, it can hurt in the short term. That’s because companies may have to sell off excess inventory at a lower profit margin, or even at a loss.
But over the medium and longer term it tends to even out. That’s because when the company restocks its inventory it buys stock at a lower price and can therefore recover its margins.
However, the elites hate deflation.
They hate it for two reasons. First, they foolishly think that, if it begins, prices will fall in a never-ending downward spiral. They think that consumers will never buy anything ever again.
They think that consumers will assume that prices will always get cheaper, and so there’s no need to buy today when they can buy cheaper tomorrow.
It’s a foolish and illogical argument.
For a start, consumers are people. People have ongoing needs. People will continue to do their weekly shopping at the supermarket. You can’t postpone food shopping for a year or more in the belief that your grocery bill will be cheaper if you wait.
But people have wants too. Everyone knows that the big screen TV that costs $1,500 today will only cost $999 in six months. Or that if they wait six months the model that’s currently $2,000 will only cost $1,500.
But guess what? They want it now. The naturally tendency to want something is hard to resist.
In short, the supposed three-headed deflation monster is nothing of the sort. If governments and central banks would stop worrying about deflation, economic recovery worldwide would have happened long ago.
But, they are fearful of deflation. And in their world, they have every right to be…
Why banks hate deflation
Deflation has another impact on another type of business — banks.
While most businesses should be able to weather the short term storm of deflation, it’s much harder for banks to do the same thing.
When a consumer takes out a loan, it will have a principal and interest component. The principal part of the loan repayment doesn’t change, regardless of the prevailing interest rate.
The thing that changes is the interest component as rates rise and fall.
It’s the principal part of the equation that creates the problem for banks. In a deflationary environment, interest rates should be low. That’s helpful as it makes it easier for the borrower to repay the loan.
However, the principal payment doesn’t change. So if prices fall and therefore wages fall, the principal part of the loan repayment becomes a bigger burden for the borrower — as a percentage of their income.
That makes it harder to repay the loan, and it can lead to an increase in bad loans and bad debts for the banks. This is what worries the banks most.
If customers can’t repay the principal, it could send the banks bust. That wouldn’t be good news for the governments and central banks, as they know the people would expect them to ‘make good’ on the savings people hold at the banks.
An opportunity for speculators
This is why the ECB is so scared of deflation. Europe’s banks are already in a bad way. The ECB worries that if prices fall, then wages and profits will fall, and that this could put further pressure on bank balance sheets.
In short, it’s a mess. But as always, any mess creates an opportunity.
Europe’s major markets, such as the UK and Germany, are trading near record highs. But there are other European markets that haven’t recovered to a new high.
Right now, anything in Europe is a speculation. There’s no guarantee that the ECB can repeat its ‘whatever it takes’ formula to stimulate the market.
But it’s worth watching. Central banks hate deflation, and they’ll do anything they can to prevent it.
That likely means a continuation of low interest rates and more money printing.
Kris Sayce is an Investment Director for Port Phillip Publishing
and an editor for Money Morning Australia.