Europe slides towards deflation
Greece, as is often the case, is a bellwether for all that is going wrong in Europe. Among the latest woes for an economy that has contracted for six years straight is deflation.
Greece has battled deepening deflation since reports showed prices fell 0.2% in the year to March.1 By the 12 months ended November, deflation was running at an annual pace of 2.9%, thanks in no small part to a jobless rate of 27% triggering a 12% plunge in wages.
In recent months, the list of eurozone economies suffering from annual deflation peaked at four; Cyprus, Ireland and Latvia, which started using the euro on January 1, are the others featured. This deflation roll threatens to expand because in November prices dropped in Belgium, Estonia, Italy, Luxembourg, Malta, the Netherlands, Portugal and Slovenia, while prices were flat in France, Finland, Slovakia and Spain. (See table below.) For the eurozone, prices slid 0.1% in November and only rose 0.9% in the 12 months to November. (Eurostat said on January 7 released as estimate that showed prices in the eurozone only rose 0.8% for 2013.) Such is the concern about deflation on top of a jobless, banking and sovereign-debt crisis that the European Central Bank in November unexpectedly cut the cash rate to a fresh record low of 0.25%, in a bid to get prices to inflation at closer to its 2% target.
No one should be surprised by Europe’s slide towards deflation. It’s the logical and foreseeable consequence of the austerity and market-based reforms inflicted on bailed-out countries. The worry for investors is that deflation carries big risks for Europe if it spreads and that policymakers are split on how to stop deflation infecting more countries.
A brief spurt with deflation in peripheral countries won’t damage the eurozone, to be sure. It’s probably more likely that eurozone prices will rise at some sluggish rate in coming years, rather than tumble. Surveys show that people still expect prices to rise at an annual rate of 2% or over the next 12 months (perhaps a side benefit of all the spurious warnings about inflation). There is such a thing as “good” deflation too. Greater productivity due to technological innovations or supply shocks such as the entry of China’s cheap workforce into the world economy from 1978 can lead to benign declines in prices that raise living standards.
The deflation taking hold in bailed-out peripheral countries might not be classed as “good” as it is accompanied by crippling unemployment but the relative price adjustments has benefits. It is helping these countries regain their international competitiveness – Ireland, Portugal and Spain are now posting current-account surpluses and Greece is close to one. For within a fixed exchange-rate system, the only way current-account deficit countries can re-grasp their export edge is to engineer lower inflation rates than those prevailing in surplus countries. Since inflation in creditor countries is low, that means deflation for debtor nations. But even if there is this competitive benefit, the deflation in peripheral countries threatens to mutate into the “worst kind of deflation”, as Reserve Bank of Australia’s Glenn Stevens described this danger in 2003.2 This is when a slump in domestic demand leads to a “persistent and widespread expectations of falling prices” that becomes a self-perpetuating downward spiral. Such an outcome cripples, among other victims, people and countries with excessive debts – and government debt in the eurozone has now reached 93.4% of GDP.3
Euro straightjacket
A glance at the 1930s shows how devastating deflation can be and why it is taking hold in Europe. Many economists now trace the scourge of the Great Depression to the flawed nature of the gold standard to which countries including Australia adhered. Pre-World War I, this fixed-exchange-rate regime soothed current-account imbalances by inflicting a dose of deflation on deficit countries and inflation on surplus countries – thus restoring balance among the gold-pegging countries. (A trade deficit led to gold outflows, thus a contraction in the money supply, which lowered prices, and vice versa. The rebalancing, called the “price-specie flow mechanism”, was underpinned by lending from surplus to deficit countries.)
But in the 1920s, financial distortions from the cost of the war and the fact that countries fixed their currencies to gold at inappropriate levels sabotaged this mechanism. For various reasons, surplus countries such as the US stopped recycling the lending that trade-deficit (and gold-losing) countries such as Germany needed to soothe balance-of-payments crises. Deficit countries were forced into deflationary spirals that triggered depressions to maintain their fixed exchange rates and restore competitiveness. Countries only escaped deflation by quitting the gold standard. Australia took this recovery option in 1932.
The euro is a more rigid system than the gold standard. Unlike the gold peggers, members of the eurozone lack their own currency, so can’t readily quit the exchange-rate system. Euro users lack their own monetary policy. They share a half-baked central bank, one that lacks lender-of-last-resort powers. The sole macro tool of policymakers is fiscal policy, though; through fiscal policy and other powers, they can implement reforms to regain competitiveness. That’s why policymakers felt they had little choice but to inflict a dose of austerity-induced deflation (an “internal devaluation”) to make their countries export fit again.
Bad deflation is a curse anywhere. It weakens economies as it boosts real interest rates (even if nominal rates are 0%). It prompts consumers to postpone purchases in the hope that goods will be cheaper tomorrow. The resultant slump in sales forces businesses to cut prices, which reduces their profits. Bad deflation drives up real debt burdens. Under the euro straightjacket, this combination could prove lethal for the eurozone. A deflating economy battering government revenue and forcing more spending on social security is bolstering debt-to-GDP ratios to the point of default, especially for Greece. At the end of the second quarter, this ratio stood at 169% in Greece, 130% in Italy, 131% in Portugal and 92% in Spain.4 The other reason why deflation is dangerous for southern Europe is that it makes it difficult to attack the jobless crisis that is sapping political stability in troubled countries.
Policy loggerheads
The deflation in peripheral countries reveals how eurozone policymaking is at cross-purposes. By cutting rates, the ECB is acting against the austerity (deflationary) policies that are making the struggling countries more competitive but which boost their likelihood of default. The central bank’s as-yet-unused pledge to buy the government bonds of troubled countries and its lending to commercial banks against junk assets are other ECB policies that hinder the competitive recalibration in southern Europe. There is no guarantee that rate cuts or unorthodox monetary policies, which could one day include quantitative easing, will help peripheral economies grow enough anyway to allow governments to get their debts under control. Their banks have too many dud loans to resume normal lending. The risk is that ECB’s steps to combat deflation will only over-inflate housing and other asset markets in creditor nations, especially in Germany.
There are solutions to preventing deflation taking hold across the bloc. But they involve the creditor nations – that is to say, Germany – agreeing to higher inflation. If Germany allowed its inflation to rise to, say, 5% then Greece could regain competitiveness with inflation of 2%. But as Germany’s inflation is 1.2%, deflation it must be for Greece. Alas for Greece and others, there is little chance of Berlin agreeing to a higher inflation target for Germans are still tormented by memories of the hyperinflation of 1921-23 – perversely forgetting how deflation and unemployment helped Adolf Hitler ascend to power. In fact, Germany is putting downward pressure on its inflation by reducing its fiscal deficit at a time when its neighbours would benefit from more domestic demand in Europe’s largest economy that expanded just 0.3% in the third quarter. Even as fiscal policy is squeezed in Germany, inflation fears triumph. Chancellor Angela Merkel told an election rally last year that the ECB “for Germany … would have actually have to raise rates” to dampen inflationary pressures.5
Such thinking helps explain why the two German members of the ECB’s 23-strong policy-setting board led a six-vote attempt to prevent the ECB’s rate cut in November. Influential German economists and mainstream financial media slammed the rate reduction, in what is another example of how perceived national interests being placed ahead of the eurozone’s welfare dog the continent’s future.
Frustration is growing at Berlin’s attitude against regional solutions such as a proper banking union (which would help resume lending and snip the suicide-pact between governments and banks), shared debt (eurobonds), fiscal transfers and higher inflation. The best hope for the eurozone may well be that German self-interest demands that it consider the welfare of the region, not least of all because EU members take nearly 60% of its exports. Troubled neighbours absorb rescue money and any default by a eurozone country or departure from the euro could wreak huge losses on Germany. Another hope is that Germany’s new ruling coalition between Merkel’s centre-right Christian Democrats and the leftist Social Democrats was moulded on promises to boost pensions and wages and boost fiscal spending.
The pressure on Berlin and other creditor countries to boost their economies will only grow now the deflation in southern Europe threatens to blight the eurozone. But it’s questionable whether enough pressure can be mustered against the danger of deflation to prompt an imminent solution that prioritises the welfare of the region above all.
Inflation figures come from Bloomberg and Eurostat while other financial information comes from Bloomberg unless stated otherwise.
Inflation in the 18 countries in the eurozone
Eurostat release 196/2013. “Euro area inflation up to 0.9%”. 17 December 2013. Countries ordered as done by Eurostat.
http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-17122013-AP/EN/2-17122013-AP-EN.PDF
1 Hellenic Statistical Authority or ELSTAT. Consumer price index. Timeseries 03. Comparisons of the overall consumer price index (2009+100.0). The main El.Stat page in English is: http://www.statistics.gr/portal/page/portal/ESYE
2 Glenn Stevens, the Deputy Governor of the Reserve Bank of Australia. Speech to the South Australian Centre for Economic Studies April 2003 Economic Briefing. 10 April 2003. Copy published in the Reserve Bank of Australia Bulletin, April 2003. http://www.rba.gov.au/publications/bulletin/2003/apr/pdf/bu-0403-3.pdf
3 Eurostat. “Euro area and EU28 government debt up to 93.4% and 86.8% of GDP.” 23 October 2013. http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-23102013-AP/EN/2-23102013-AP-EN.PDF
4 Eurostat. Op. cit.
5 Reuters. “Update 1 – Merkel: ECB would have to raise rates if looking at Germany only.” 25 April 2013. http://www.reuters.com/article/2013/04/25/germany-ecb-merkel-idUSL6N0DC26720130425
———————
by Michael Collins, Investment Commentator at Fidelity
