04/14/2015 10:51 am ET Updated Jun 13, 2015

Why Europe's Deflation is Everyone's Problem

Deflationary forces have been kicking up turbulence in Europe, prodding eurozone leaders to finally embrace quantitative easing (QE) as a way to drive economic growth. The facts became undeniably clear when December reports showed that the eurozone dipped to a -0.2% inflation rate year-to-year. For the first time since 2009, the eurozone's inflation rate was officially in the red, bringing Europe's anemic recovery effort front and center.

Unfortunately, deflation is not just Europe's problem. It's a trend that has an effect on countries around the world, especially major economies like the U.S. and China. "Europe is big enough to effectively 'export' its deflationary problem to the rest of the world," Twitter notes Krista Schwarz, a Wharton finance professor.

"Europe is 25% of the global market," adds Mauro Guillén, Wharton management professor and director of The Lauder Institute. "The U.S. and China sell in Europe. The problem is essentially that deflation will produce very slow growth worldwide."

A Healthy Benchmark

What's widely accepted as a healthy benchmark for a country's inflation rate is 2%. Currently, onlyone-fourth of the world's 90 economies are below 1% and half of those are in deflation, according to a report from consultancy Capital Economics. "No major economy is facing a lot of inflation. Even the U.S. is facing contained inflation," says Olivier Chatain, strategy and business policy professor at HEC business school in Paris and senior fellow at Wharton's Mack Institute for Innovation Management.

Deflation is when general price levels fall; essentially, goods and services become cheaper because their prices are not rising due to a lack of inflation. Companies make smaller profits, decreasing cash flow. Consequently, this can result in layoffs and freeze any new hiring, thereby increasing unemployment. Deflation was a major cause of the Great Depression in the U.S. and stagnation in Japan over the last two decades.

"Wages do not typically fall by as much as prices in the industries facing weaker consumer demand," explains Kent Smetters, a Wharton business economics and public policy professor. "That asymmetry produces more unemployment since producers must lay off workers rather than pay everyone a bit less."

Moreover, consumers have less money to spend, thereby driving down the demand for goods and services, causing a surplus in goods. Another scenario is "consumer deferral" when people wait to buy something, like a new couch, betting on the possibility that prices will come down later. As a result, goods don't move very quickly in the marketplace. Also, financiers wait on making investments, banking on prices dropping further. Loans are also more expensive to pay back as the value of money drops.

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