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Deflation is Europe's major concern
Thu, 1 Dec Pre-Open

The European debt saga has been going on for a long time now. Just when there seems to be a resolution reached with one country, the next country falls on the brink of disaster. No real solution seems to be at hand and markets are wallowing in the red as a consequence. CNBC, Senior Editor John Carney however believes that the reason for the trouble is a lack of a clear understanding of the issue.

Most policymakers and central bankers don't realize that the Euro zone is going through a monetary contraction or a severe deflation. This is contrary to the belief that inflation is being stoked within the region. To understand what exactly is happening in the region we have to go back a few years and understand what really caused the subprime crisis. In the US triple rated mortgage-backed securities served as cash equivalents in the system. They were highly rated and highly liquid securities which investors were only too eager to hold on to. These served almost as well as US Treasury bonds which is also serves as money. But, when the bottom fell out on the housing market, there were no takers for these subprime securities. Thus there was a severe loss of monetary equivalents within the banking system. Even the billions that the Fed pumped into the economy could not repair this loss. Thus, even though there was an increase in the cash floating around in the economy, it did not lead to inflationary pressure in America.

Now a similar situation is taking place in Europe. Sovereign debt issued by euro nations also served as a cash equivalent within the banking system. Banks were not required to hold reserves against sovereign debt. These bonds sufficed as well as Euros. But, when Greece was about to go bust the actual value of these bonds came into question. Discounting of the value of these bonds means that there is less money within the banking system.

This instead of a Debt crisis the zone is actually experiencing a Devaluation crisis. Its cash equivalents are shrinking. Not only Greece but the government debt of Italy, Spain, and Portugal are also in question. And before long even other nations may join the fray. Policy makers need to realize what exactly is happening within the complex system. Else they may take some wrong action and the region may actually land up in a worse position than it is in now.

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