Eurozone deflation threat to UK

http://www.bbc.co.uk/news/business-30724801

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There is an argument that falling prices in the eurozone, deflation, are good news for them across the Channel but pretty awful for us here in Britain.

How so?

Well the big contributor to falling prices is the tumbling oil price, which saw the cost of energy fall 6.3% in December - and will generate even bigger reductions in the weeks and months ahead, as prices at the pumps adjust.

As I've been boring on about, cheaper fuel puts money into the pockets of consumers and businesses - and it is possible, even likely, that they will spend at least some of that, thus stimulating the economy.

Let's be clear, there's not exactly rip-roaring inflation in other sectors of the eurozone economy. Prices of industrial goods (excluding energy-related ones) were flat - although actually that's an improvement on the falls of 0.1% in the two preceding months.

And in the biggest and most important sector, services, there is inflation of 1.2%, unchanged through the autumn.

Stripping out items which are to a large extent determined by global demand conditions - energy, food, alcohol and tobacco - prices rose 0.8%, again pretty much unchanged through the autumn.

Or to put it another way, there is not endemic deflation yet in the eurozone. We are not yet witnessing a pernicious Japanese-style mindset for households and companies, that there's no point spending today if goods and services can be bought cheaper tomorrow - which is what would create a vicious spiral of falling prices engendering ever shrinking demand and activity.

Of course deflation would create the second whammy of the eurozone's debt become bigger in "real" terms.

And we should be under no illusion that the deflation threat is a real one - especially since the important characteristic of the euro area is stagnation, with worryingly high unemployment refusing to come down.

So that's why today's economics in the eurozone are worrying, but not yet devastating.

However, because the risk of deflation is a real one, the likelihood is that the president of the European Central Bank, Mario Draghi, will win his battle with the Germans such that later this month we will see the central bank catch up with the US Federal Reserve and the Bank of England by launching quantitative easing involving the purchase of government bonds.

Earlier this week I wrote of my concerns that the QE scheme to be announced would be a sub-optimal hybrid.

But to state the bloomin' obvious, the more that investors and markets become hysterical about possible incipient deflation, the more likely it is that Mr Draghi's QE will be bigger and bolder.

That in effect means that interest rates in the eurozone will drop even more - that the cost of debt and money will drop below even their current lows.

More relevantly to us, the euro will become even cheaper relative to the pound.

Which is why, to go back to where I started, eurozone price falls are very bad news for Britain.

Because, as you know, my big concern about the UK is its massive 6% current account deficit - the gap between what we earn from the rest of the world from our trade and investments and what we pay to the rest of the world.

Now we already have significant trade deficits with Germany (with which our trade deficit is the biggest of all our trading partners), France, the Netherlands, Belgium/Luxembourg, and Spain.

Our deficit on trade with the euro area is the biggest of any country - between January and September of this year, it was 70.3bn euros or £55bn, up from 54bn euros in the comparable period of the previous year.

All other things being equal, a weakening euro will widen that deficit further - as UK exports to the euro area become more expensive, and imports from the eurozone become cheaper.

Or to put it another way, the European Central Bank's putative cure for eurozone deflation is to export it to us - strengthening sterling will harm our exporters and put our already low inflation rate of 1% under downward pressure.

Now this danger that we import their deflation is happening while we have bigger aggregate indebtedness than most of the eurozone (that's household, business and government debt as a share of GDP or national income) and that indebtedness is being exacerbated by our intractable inability to pay our way in the world.

If serious deflation took hold in the UK, we would experience a hideous combination of economic stagnation and growing doubts about our ability to service our huge debts.

Mario Draghi's supposed cure for the eurozone's economic woes could be toxic for us.