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Europe's Real Problem? Deflation
CNBC.com | November 29, 2011 | 10:28 AM EST

European markets experienced a rare moment of respite yesterday, but this was just a pause in the panic. No comprehensive solution to the continent’s sovereign debt woes seems to be near at hand.

Why can't policymakers and market participants come to a consensus about what needs to be done? I suspect the problem is a serious misunderstanding about what is actually happening in Europe and why it will have dire economic consequences.

Europe is experiencing a stealth monetary contraction, which is another way of saying it is undergoing massive deflation .

This might sound odd to many readers. The voices out of the European Central Bank all sound the alarm of inflation . And it’s not just the central bankers. Journalists too start clanging on about inflation whenever a serious plan for addressing Europe’s problems is proposed.

“The European Central Bank is under mounting pressure to take a leaf out of the Federal Reserve's 1940s playbook by setting caps on government bond yields, a move that may stoke inflation,” John Glover at Bloomberg wrote recently .

What the inflationistas are missing is that Europe is actually suffering from a profound contraction of its money supply. This contraction is crippling the banking system and will bring the economy to a grinding halt if it is not allieviated.

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