Thursday, November 24, 2011

Krugman Leaves the Thanksgiving Dinner Table to Warn About Deflation!

When you are Paul Krugman, you see deflation everywhere, even on Thanksgiving day, when  the price of Turkey dinners are up 13%.

Specifically, Krugman steps away from his turkey dinner to warn about deflation in Europe. He writes:
I really wasn’t planning on blogging on Thanksgiving Day. But what’s going on in Europe deserves a mention.

So, the big story: German bonds are now being priced as a risky asset — what the FT calls the “apocalypse trade“. The interest rate on bunds, at 2.21% as I write this, is still very low by historical standards. But it’s above the rate on UK bonds (2.17%) and way above the rate on US bonds (1.88%).

The way to see this is that the market is in effect pricing in a real possibility of eurozone collapse.

In particular, market expectations seem to assume that the ECB will remain utterly indifferent to its responsibilities. The German breakeven rate, an implicit forecast of inflation over the next 5 years, is just 1 percent. That’s a disaster level, implying severe deflation in the debtor nations — or, more likely, a euro breakup.
Krugman gets this most right except for the warning about deflation. Either German Chancellor Angela Merkel agrees to the European Central Bank money printing, which will cause huge price inflation in the eurozone, or the eurozone breaks up. In other words, inflation is the real threat, if Merkel gives the thumbs up on ECB money printing. But, if the EZ breaks up, it's a good bet that some of the EZ countries, such as Greece, will start their own money printing programs. No deflation in sight.

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