The Dreaded D Word

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For those irked by displays of economic self-righteousness, one word sums up the emotions aroused by Germany's current economic plight schadenfreude, joy at another's misfortune. For years, Germany, like Japan, held itself up as an economic paragon. The mighty deutsche mark was the very icon of sound monetary management; Bundesbank presidents scolded fellow Europeans as feckless passengers on a gravy train pulled by the German locomotive.

How are the mighty fallen. It isn't just that Europe's largest economy is at a standstill, with unemployment at almost 10%. What's truly frightening is that inflation in Germany is so low that the dreaded D Word deflation, a mega price collapse is now a real concern. For Europe's erstwhile bulwark against inflation, the irony of the new situation is painful: the specter of deflation has replaced the ghost of Weimar Germany when people needed wheelbarrows to transport their devalued deutsche marks.

What's so scary about declining prices? If bargain basements proliferate thanks to stiff competition, or if productivity gains can be passed along in the form of lower prices, aren't we all better off? Trouble is, there's a big difference between the price cutting we welcome on the high street what economists call disinflation and deflation, which involves a downward spiral of falling prices, squeezed profits, lower incomes and falling demand spread across an entire economy. The process feeds on itself: sluggish demand leads to price cuts for goods and services as firms compete for customers. They then compensate for eroded profits by slashing costs, which usually means laying off workers. That reduces household incomes and further undermines demand, so the vicious cycle begins again. Human nature doesn't help: when prices tumble, people postpone purchases to await better deals, weakening demand still more.

High levels of debt make deflation even more pernicious. That big mortgage is affordable if house prices are rising and the ratio of debt to equity is declining. But if house prices collapse, then the real debt burden increases. When Japan's property boom turned to bust a decade ago, the result was a disaster for the banks, which saw the value of their collateral evaporate. Although Germany has so far been spared a Japanese-style property collapse, commercial real estate and home values have taken a hit in the past two years and a wave of corporate bankruptcies has forced Germany's big banks to double their loan-loss reserves to almost 8 billion.

Economists argue about what causes disinflation to morph into deflation. But they agree that once the process starts it's as destructive and hard to stop as an avalanche. The last bout of serious deflation resulted in the Great Depression of the 1930s and it took the stimulus of World War II to break the vicious circle of contracting demand and declining prices.

With inflation in Europe and the U.S. at its lowest level for 40 years (and with higher private-sector debt levels than on the eve of the Great Depression) deflation is an unclear but present danger. One troubling omen is what the O.E.C.D. calls the output gap the difference between what an economy could produce and what it is actually producing. In Europe, as in North America, excess capacity in industries from autos to airlines continues to exert downward pressure on prices as firms go after the orders needed to keep factories operating or the passengers needed to fill their planes. Overall, the euro zone currently has an output gap equivalent to around 1.6% of GDP, but in Germany it is 2.6% of GDP, second only to Japan. That helps explain why producer prices in Germany have been generally falling for nearly two years and why some economists think Germany is the leading candidate to follow Japan into deflation. Bundesbank president Ernst Welteke insists that deflation fears are exaggerated. Let's hope he's right, because a Germany in deflation, like a black hole in space, could suck in others, especially its euro partners.

So what's the way out? Lower interest rates would help, but don't hold your breath. Nowadays these are set, not by the Bundesbank, but by the European Central Bank, which manages monetary policy for all euro members, not just the biggest. So because some countries need reining in, Germany suffers interest rates that are higher than its inflation rate warrants and its economy needs. Berlin could compensate by easing fiscal policy, but the government is actually contemplating raising taxes to cut its deficit. Ironically this counterproductive action is mandated by the very E.U. stability and growth pact Germany demanded to deter fellow euro members from tax-and-spend profligacy.

There remains one surefire way to ensure that inflation stages a comeback and sends the Big D back to the textbooks: oil price hikes resulting from conflict in the Mideast. But worrying as the threat of deflation is, especially for Germany, nobody needs a cure that's as painful and deadly as the disease itself.