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It seems clear today that deflation is taking hold in most southern European countries which use the Euro. Declining asset prices create a vicious spiral of falling output, declining incomes and increasing unemployment. It also leads to higher loan default by business and individuals and further lack of consumer demand.

To counter the effects of deflation the ECB needs to take some fairly urgent ‘none standard measures’. Increasing the money supply and negative interest rates are possibilities. Euro devaluation is another.

Price inflation hardly exists in the Eurozone. Asset price inflation is a necessary stimulant to growth and without it economies simply continue to stagnate.

A perfect example of the consequences of deflation is what happened in Japan in the nineties. Zero interest rates and stimulation failed to have any impact. Deflation lasted for over a decade and led to a series of devaluation of the Yen.

If the ECB devalue the Euro it will likely lead to a major tit for tat currency war. I think that’s unlikely but the tools available to the ECB to counter deflation are now very limited.

The point of this post is to point out to anyone currently considering investment in Spanish property is to consider the likely effects deflation will have in the coming decade.

Further value fall is an obvious one but also the rising over head cost of maintaining the property is another. Deflation seems to only have a limited effect on these costs as urbanised communities struggle with defaulting owners who can no longer afford the community charges.

In effect the owners who pay subsidise those who don’t or cannot. As there becomes fewer payers the costs inevitably rise leading to a further spiral of default. The same effect happens with taxation. Taxes rise to compensate for the decline of government revenue streams.

Deflation also creates serious economic uncertainty in a country. Spain seems now to have got used to it and of course hope for better times. However the signs for recovery are limited. Exports are improving but that alone will not lift the country out of the mire it currently finds itself in.

These are uncharted waters for the single currency and I predict further serious political and monetary crisis for the EU in 2014.

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