IMF: Euro zone in jeopardy from ‘significant’ threat of deflation

Europe could suffer a dangerous bout of deflation if regional officials, including those at the European Central Bank, do not move quickly to support the continent’s banks and the wider economy, the International Monetary Fund warned Wednesday.

Using some of its most ominous language yet, the usually understated IMF called the euro zone “unsustainable” in its current form. The agency said the 17-nation currency union is a “half-finished” project and could disintegrate as banks and other nervous investors shelter money in their home countries rather than letting it flow across the euro zone.

The currency union was created in an effort to integrate the economies and financial markets of European countries. But the two-year-old financial crisis “has created de-integrating forces” that have put the euro in jeopardy, IMF fund officials wrote.

“Financial markets in parts of the region remain under acute stress, raising questions about the viability of the monetary union itself,” they wrote.

Europe’s financial problems are among the chief dangers facing the world’s weak economic recovery, undercutting global trade and causing investors to shy away from risky investments. The euro crisis has already become a drag on growth, from the United States to China.

In its report, the IMF warned that the crisis is reaching a point where a mild recession could give way to a more destabilizing round of deflation. Just as prices that rise too quickly can hurt a nation’s economy, falling prices can create a corrosive spiral that leaves consumers hesitant to spend because they hope prices will fall in the future. Meanwhile, companies and households can be pushed into bankruptcy as real estate and other asset prices fall, and banks can be saddled with potentially ruinous levels of bad loans.

The risk of a “debt-deflation spiral” is “significant” in troubled countries such as Italy and Spain that desperately need their economies to begin growing, the agency said.

New data from the Spanish central bank on Wednesday highlighted the troubling dynamics: a steady drain of deposits from banks, falling real estate and asset prices, a continued rise in bad loans. The country is in the process of negotiating a $120 billion bailout of its banks to be paid for from Europe’s rescue fund. But the terms and timing of the bailout remain unclear, as do other key conditions — notably the degree to which the Spanish government would have to guarantee that the money will be repaid.

European leaders have convened a long series of summits, changed regional treaties, agreed to bailouts and taken steps toward common budgets, banking oversight and jointly issued debt. But the plans have yet to take effect in full, many crucial issues remain unresolved, and national leaders have been slow to find ways to kick-start economic growth.

Referring also to a “potential deflationary scenario” in Europe, Carl Weinberg, chief economist at the High Frequency Economics consulting firm, said that to date “there are no policy measures in sight that can make a difference in the process that is causing the downturn or in the downturn itself.”

The risks are so great that the IMF has been persistently upping the pressure on the European Central Bank to use its powerful economic tools to address the crisis — or at least buy more time for Europe’s political leaders.

In a series of interviews, reports and statements this week, the IMF’s top economists have urged the ECB to intervene more directly in European bond markets and take other steps to ensure that the governments of Italy and Spain, for example, remain able to borrow money on their own and avoid the need for an international bailout.

The ECB recently cut interest rates to a historic low. But ECB President Mario Draghi has been hesitant to use more of what he calls “non-standard measures” — steps such as bond buying that the bank has used at different points in the crisis but that some euro zone countries, most notably Germany, have opposed.

In its report, however, the IMF suggested the ECB consider a wide range of steps — including the type of “quantitative easing” the U.S. Federal Reserve has used to increase the money supply and boost growth, as well as steps to hold down the borrowing costs of troubled governments.

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