The European Central Bank cut interest rates to a new low in an effort to stimulate the eurozone economy and fend of deflations. But deflation is not the danger bankers should be looking to avoid, says DW's Rolf Wenkel.
Rolf Wenkel is an editor on DW's business desk
The central bankers' decision to drop rates for the 17 members of the eurozone to 0.25 percent from 0.5 percent was not completely unexpected. Alarm bells went off for many when the inflation rate in the 17 countries using the euro fell from 1.1 percent to 0.7 percent. Many observers see the eurozone heading down a path toward deflation and conditions similar to those experienced by Japan. The Asian country needed over a decade to free itself from deflation's stranglehold and book anything that resembled significant economic growth.
Deflation implies that companies are forced to lower prices, largely due to low or non-existent demand. This means that goods and services tend to get less expensive. But what sounds like good news for consumers has an unpleasant side effect: if businesses and people expect prices to continue falling, they wait for prices to fall further before making purchases.
Putting off purchases - economists call it a wait-and-see position - has devastating consequences. Not only do consumption and domestic demand fall, but companies also delay their investments because their sales have dropped. This creates a spiral of sinking prices, sinking production and a swell in job cuts that is extremely difficult to stop.
That's is probably the reason the European Central Bank (ECB) took the classical monetary control instrument at its disposal and halved interest rates from their already low levels. Whether the move is enough to give the eurozone the economic push it needs is yet to be determined. As they say, you can lead a horse to water, but you can't make it drink. Or, put another way, companies don't invest because cash is cheap, they invest because they expect demand to increase. And, unfortunately, demand is growing at a very slow rate, as seen by the most recent economic prognosis from the EU Commission.
So why is the inflation rate so low at the moment although many observers see the central bank's cheap money policy as a potentially large source for inflation and price bubbles? The fact is that opening the cash floodgates and bringing interests rate to 0 percent does not rule out the possibility that inflation stays at moderate levels - at least in the short term. But take the long view, and large price bubbles become possible. After 9/11, the US Fed loosened its purse strings to prevent a recession. Then it took about eight years for the real estate bubble to burst. The consequences of that explosion are well known and the global economy has still not completely recovered from it.
There is quite simply no other course: over the long term, the ECB will have to move away from a cheap money policy, and the bank does not have to unconditionally follow the policy set out by the US Fed. In the long run, the eurozone will not have to fight deflation but against the creation of new price bubbles and new crises.