Research & Commentary

Disinflation in Europe – Deflation Ahead?

Eurozone money is growing at a slower rate. That may be ominous.

The German central bank, the mighty Bundesbank, is famously fixated on the money supply. This is a legacy from the hyperinflation that occurred in 1923 when the Weimar government in Germany ran the currency printing presses 24 hours a day in order to help pay war reparations. So worthless had money become that workers were paid three times a day, wheelbarrows became wallets and, as the inset shows, children used wads of Reichsbank marks as building blocks. Historians conventionally link this traumatic experience to sowing the seeds of the fascism that flourished in the 1930s.

Not surprisingly given the devastating consequences that had in Europe, the Bundesbank’s focus on money supply has transferred over to the modern-day European Central Bank (ECB). The ECB likes to see steady, boring growth in money. Anything else will grab its attention. So over the course of the past year, a few eyebrows will have been raised at the disinflationary trend emerging in M3 Money Supply growth. It’s tempting to think that a central bank has a simple control on money supply growth rates. If it’s too high, they create less money, and if it’s too low, they create more. But the truth is that, whilst a central bank can influence money supply to some extent, the natural cycles in social mood will be the driving force in money and credit creation. This is especially true when mood turns negative, as it did in 2008, when M3 growth plummeted from inflation of 12.5% per annum in 2007 to deflation in 2009. When money and credit growth starts slowing (disinflation), it’s a sign that fuel is draining from the economy. Sometimes, that leads to deflation and a shrinking economy.

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