IMF: Eurozone risks deflation, breakup

July 19, 2012 at 3:00 AM

FRANKFURT, Germany, July 19 (UPI) -- Slow-growth eurozone nations risk deflation, and persistent debt concerns put the eurozone's future in doubt, the International Monetary Fund warned.

Countries such as Italy and Spain, where growth is slow and governments are counting on tax increases to reduce their staggering debt, face a 25 percent risk of consumer price deflation before 2014, the fund said.

Deflation, falling prices, can lead to a spiral in which price decreases lead to lower production, which leads to lower wages and demand, which in turn leads to further price decreases.

Companies and households hesitant to spend because they hope prices will fall in the future can be pushed into bankruptcy as real estate and other asset prices fall. Banks can be saddled with potentially ruinous levels of bad loans.

A deflationary spiral would additionally increase the difficulty for countries like Italy and Spain to control government debt because falling prices and wages would further depress tax receipts, the fund said.

In those countries, "administrative price and tax increases are masking more severe downward price pressures from still substantial output gaps," the fund said.

Spanish Finance Minister Cristobal Montoro Wednesday said sales-tax increases to 21 percent and comparably drastic government-spending cuts were needed not just to pay down debt but also to pay public-sector salaries.

"There is no money in the state coffers," Montoro told Spain's Congress of Deputies. "What we have comes from taxes, and if revenues don't increase, we are at risk of not being able to meet the payroll."

Spain's Cabinet Friday approved the largest austerity package since democracy was restored in Spain in 1978.

Even a mild recession could tip weaker eurozone countries such as Spain into deflationary spirals, the report warned.

The IMF said the eurozone was "unsustainable" in its current form and could disintegrate as banks and other investors protectively shelter money in their home countries rather than letting it flow across the 17-country economic and monetary union.

"The euro area is in an uncomfortable and unsustainable halfway point," the report said. "While it is sufficiently integrated to allow escalating problems in one country to spill over to others, it lacks the economic flexibility or policy tools to deal with these spillovers."

Eurozone countries eventually need to issue common debt through so-called eurobonds and cede some authority over their national finances for the sake of the currency and European stability.

Germany and some other mostly northern European countries say they oppose eurobonds and other joint-liability proposals because they may remove pressure on troubled governments and banks to clean up their financial acts.

France and other countries favor eurobonds but say they are not willing to give up control over their own budgets.

To save the zone from the current financial crisis, the IMF called on the European Central Bank to take steps similar to those of the U.S. Federal Reserve and the Bank of England, and start a major bond-buying program, known as "quantitative easing," to stimulate the economy.

The ECB had no immediate comment on the recommendation.

The eurozone's central bank has spent more than $260 billion buying bonds since 2010 but has resisted calls to join the Fed and Bank of England in making much larger purchases -- measures ECB President Mario Draghi has labeled "non-standard measures."

Many economists say the Fed's purchase of hundreds of billions of dollars in bonds over four years has helped the U.S. economy recover from the crisis faster than most of Europe, The New York Times reported.

Quantitative easing is how central banks stimulate the economy when they have already pushed interest rates as low as they can go.

The ECB cut its benchmark interest rate to 0.75 percent this month -- its lowest rate ever.

Germany, the bank's biggest contributor, says it opposes quantitative easing because it would amount to using the central bank to finance governments.

IMF European adviser Helge Berger told reporters in a conference call Wednesday quantitative easing was "an essential part of the ECB fulfilling its mandate."

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