Monday, April 27, 2009

Is Spain really facing deflation risk?

Sources: New York Times: Spain’s Falling Prices Fuel Deflation Fears in Europe; Diario El Mundo: After the drop of retail prices in Spain, Europe fears deflation risk; Diario El Economista: The Secretary-General of the OECD affirm that Spain will not face deflation, The Spanish Government discount deflation, Weber foresees little deflation risk in the EuroZone.

Since Nelson D. Schwartz from the New York Times reported on April 20 about the inevitable deflation risk that Spain will face in the next months, analysts, private entities and official sources have put forth different opinions about whether the drop of retail prices in Spain will spread the fear of a possible deflation risk (a sustained decrease in the general level of goods and services) to the rest of Europe.

Deflation occurs when the annual inflation rate (the percentage rate of change in price level over time) falls below 0%, which results in an increase in the real value of money. In March 2009, the inflation rate turned negative in Spain for the first time ever since the old Spanish currency (the peseta) was changed for the Euro. Since last month, retail prices have dropped markedly in restaurants, shops and supermarkets while the unemployment rate (15.5%) has continued to grow. The main problem here is that, as unemployment grows, consumers spend less money. In consequence, companies are compelled to reduce the price of the goods or services they offer. If sales do not recover, then the revenue would decrease, causing budget cuts and more unemployment.

Spain does not have much margin to fight the deflation risk, since the Spanish Central Bank cannot take any measures (like devaluating the currency or lowering the interest rates closer to zero) because the European Central Bank is responsible for establishing the monetary policy in the Eurozone.

However, the Secretary-General of the OECD assured the public in a press conference on April 20 that Spain is not really facing deflation risk, and that the country is only showing a normal price drop corresponding to the fall in demand similar to other countries like the U.K, France or Italy. The Spanish Government completely agrees with this perception and refuses to accept that deflation is even a possibility.

Moreover, although the New York Times warned that a possible deflation in Spain may spread to neighboring countries like Portugal, Ireland or Luxemburg, which have also experimented price drops, Axel Weber, adviser of the European Central Bank and president of the Bundesbank assures that there is little risk of deflation in the Eurozone.

1) Due to the little margin that European Union member states have to fight deflation individually; do you think that the European Central Bank should take any preventive measure to avoid a spread of deflation trough Europe?

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