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Report: Germany on Verge of Deflation

The German government says it won't happen. The IMF says it could. German economic experts aren't sure. Is deflation about to hit Europe's biggest economy?

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Deflation may mean lower prices but if people don't buy...

The German government on Monday rebuffed a report by the International Monetary Fund claiming that Germany is at high risk for economic deflation.

"We do not see this danger," said Jörg Müller, spokesman for German Finance Minister Hans Eichel.

The IMF study, published on May 18, cited an annual inflation rate currently running at under 1 percent, contracting consumer demand and meager economic growth as some of the "many indicators that suggest deflationary factors are at work in Germany."

There is no doubt that Germany is in a funk.

Growth in Europe's largest economy slowed to a meager 0.2 percent in the first quarter of 2003, and unemployment currently hovers near ten percent. The situation is compounded by labor costs that have risen by three-quarters of a percent each year over the past five years, a banking sector in crisis and record numbers of bankruptcies nationwide.

Deflation is bad news

If the IMF prognosis comes true, it will transform the ailing German economy from a bad dream into a nightmare.

Deflation -- the opposite of inflation -- is a decline in general price levels. Brought about by a reduction in public, consumer and investment spending, it often results in an vicious spiral of increasing unemployment and decreased demand, depressing the economy in a way that is difficult to turn around.

As it is, the IMF says that Germany will have limited policy options to fight deflation if it does hit. The country could get help from the European Central Bank, which could drop interest rates to jumpstart consumer spending.

ECB member and Bundesbank President Ernst Welteke raised expectations the ECB may be positioning for lower interest rates Monday, telling the German daily Die Welt that he saw room for maneuvering in euro zone monetary policy.

Expert opinion divided on deflation risk

But while the IMF prognosis is bleak, expert opinion in Germany is divided on exactly how big the deflation risk is.

Wolfgang Wiegard, chairman of the German Council of Economic Experts, which advises the German government on economic policy, said he believed the danger of deflation was small and that the economy would rally in the second half of the year. Wiegard said he expected an ECB rate cut of 50 basis points during the next month or two. "This would also react against the threat of deflation," Wiegard told reporters.

The Bundesbank's Welteke, meanwhile, issued words of caution. In an interview with Die Welt, the economist said "We are not in a recession, but I do not want to rule out that we are entering an even more diffult situation. The risk of deflation in Germany is very small, he said, however, "the situation must be watched and growth must return."

Still, Gustav Horn, economic chief at the German Institute for Economic Research (DIW), countered such views, telling the Süddeutsche Zeitung newspaper "all the ingredients are there for deflationary developments." Not alone

If deflation does hit, then Germany won't be alone. Japan is already in the same boat: its economy has been wrestling with deflation since 1995. Prices there during the first three months of 2003 were 3.5 percent lower than the same period the previous year. Whispers of deflationary pressure looming over the U.S. economy have also become audible over past weeks.

American consumer prices rose by 1.5 percent in April this year -- the lowest annual change for 37 years. The U.S also experienced deflation in October last year after low energy costs drove prices down.

But with the German government left with limited options including injecting what is left of German public funds into the economy or looking to exports to jump start growth, things do not look good. If deflation occurs, it will mean even harder times ahead.

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