ECBs deflation paralysis drives Italy, France and Spain into debt traps
Frankfurt could force down the euro at any time by signalling a determination to do something about its predicament. It has chosen not to do so
By Ambrose Evans-Pritchard
9:47PM BST 02 Apr 2014
The European Central Bank has let it happen. Deflation has been running at an annual rate of -1.5pc in the eurozone over the past five months, when adjusted for austerity taxes.
Prices have been falling at a pace of 6.5pc in Greece, 5.6pc in Italy, 4.7pc in Spain, 4pc in Portugal, 3pc in Slovenia and nearly 2pc in Holland since September, based on my rough calculations (annualised) of Eurostat monthly data.
The rise of the euro against the dollar, yen, yuan and the currencies of Brazil, Turkey and developing Asia, account for some of this imported deflation. Euroland's trade-weighted index has risen 6pc in a year.
But that is no excuse. It is the direct consequence of the ECB's own monetary policy. Frankfurt could force down the euro at any time by signalling a determination to do something about its predicament. It has chosen not to do so, hoping that a few dovish words spoken without conviction will somehow turn the global tide.
It is hard to judge at what point deflation becomes embedded in the system. Factory gate prices have been slipping since mid-2012. The pace quickened to -1.7pc in February, the steepest decline since the Lehman crisis. But this time it is not the one-off effect of a financial crash. It is chronic, and more insidious.
What happens to debt ratios at 'lowflation' rates of 0.5pc
What happens to debt ratios at 'lowflation' rates of 0.5pc
Professor Luis Garicano, from the London School of Economics, said the economic models used to predict inflation seem to be breaking down, leading to serial misjudgments. "They need to take very serious action," he told the Financial Times.
Laurence Boone and Ruben Segura-Cayuela, from Bank of America, say their "inflation surprise" index keeps ratcheting lower as one shock after another hits the eurozone, while their gauge of "deflation vulnerability" has been flashing red for most EMU countries.
The effect is deeply corrosive even if the region never crosses the line into technical deflation. "Lowflation" near 0.5pc can play havoc with debt trajectories if it goes on for long, ultimately throwing Europe back into a debt crisis. "The biggest threat to public debt dynamics is weaker-than-expected inflation. Merely lower than expected inflation, not even deflation, would lead to a significant deterioration in countries’ public finances," they said.
The bank said lingering "lowflation" would cause debt ratios to surge by 2018, rising 10 percentage points in France to 105pc of GDP, 15 points in Italy to 148pc and 24 points to 118pc in Spain.
These countries face a Sisyphean Task. Whatever they achieve through austerity is overwhelmed by the greater power of debt-deflation. The same "denominator effect" - a debt burden rising faster than nominal GDP - would engulf the private sector as well, still the Achilles Heel for Spain, Portugal and Ireland.
Moody's says "lowflation" (0.5pc to 1pc until 2018) would "reignite concerns about debt sustainability", tightening the vice on households and companies with fixed-rate debts. It would erode bank assets, risk fresh bank failures and hit life insurers through a mismatch in maturities. "Avoiding outright deflation does not fully shield the euro area from the shock: the combination of low growth and low inflation has significant implications for all sectors of the economy," it said.
Reza Moghadam, from the International Monetary Fund, says that even inflation of 0.5pc threatens to "scupper the nascent recovery" in Europe. It aggravates the North-South divide, making it yet harder for the Club Med to claw back lost competitiveness. The debt-stricken states have to carry out even more drastic internal devaluations to regain ground, but that in turn pushes up their debt ratios. "Each point of relative price adjustment must be bought at the cost of greater debt deflation," he said.
What happens to debt ratios at 'lowflation' rates of 0.5pc
"Very low inflation may benefit important segments of the population, notably net savers. But in the current context of widespread indebtedness problems, it is working to the detriment of recovery in the euro area, especially in the more fragile countries, where it is thwarting efforts to reduce debt," he said.
Once you grasp this elemental point that it is "thwarting" efforts to control debt, the spectacular idiocy of EMU policy becomes clear. Austerity as designed is self-defeating. The fundamental failure has been the ECB refusal to offset the contractionary effects with enough monetary stimulus to keep nominal GDP growing faster than the debt stock of Italy, France, Spain, Portugal and Greece, but not only for those countries.
Again, the ECB could have done this. It chose not to because it allowed its monetary policy to become infected by judgments on moral hazard outside its proper ambit, by pre-modern central banking doctrines or by fear of what Germany might or might not say.
Nowhere is this failure more obvious than in Italy, where debt has jumped from 119pc to 133pc since 2010 despite draconian fiscal tightening and a primary budget surplus. Rock-star premier Matteo Renzi has stormed into office with a 100-day New Deal, tearing up the austerity script and going for broke with supply-side reforms and a fiscal blast to kickstart growth.
Antonio Guglielmi, from Mediobanca, said markets are betting that Mr Renzi will prove to be the "discontinuity catalyst" capable of pulling Italy out of its seemingly unstoppable low-growth trap, achieving a virtuous circle that at last raises the economic speed limit and cuts into debt ratios. But even this high-stakes gambler from Florence can do little in the end against the sheer granite madness of the EMU edifice.
Mediobanca said his last-ditch mission to save Italy is doomed unless the ECB launches quantitative easing to head off debt deflation, and if he has to comply with the EU Fiscal Compact as it forces the country into a primary budget surplus of 6pc of GDP by next year. "It is up to Mr Renzi to give a loud and clear message to Frankfurt on softening austerity," said the bank.
We will find out on Thursday whether the ECB is ready to grasp the nettle of QE, or indeed any nettle. Loans to businesses are contracting at a rate of 3pc. The ECB is missing its 2pc inflation target by 150 basis points, and will continue to miss it badly in 2015 and 2016 by to its own forecasts. You could argue that this is a grave breach of of its primary mandate - not to mention its broader Treaty obligations to support growth and the economic objective of the Union - yet it still sits on its hands.
Critics have noted that German M3 growth has been on a near perfect path of 4pc to 5pc annually over the years, but let it never be said that the ECB sets monetary policy entirely in the interests of one country - whatever the devastation all around, including in Finland and Holland lately. If other governors are so supine - or so cowed by Bundesbank supremacy - that they go along with this, they deserve their fates.
Perhaps there will be a tiny cut in interest rates, or a negative deposit rate, or an end to sterilisation of bond purchases; or some such eyewash that comes a year late, is a trillion short and makes no difference. Once deflation fastens on an economy, it takes ever more radical action to break loose. Jens Weidmann, from the Bundesbank, has opened the door to QE - very slightly, seemingly for tactical reasons - but the political bar to such action is punishingly high in Germany.
The Bundesbank was over-ruled on the ECB's bond-rescue plan in 2012 (OMT) but Germany as such was not over-ruled, a point that is often misunderstood by Anglo-Saxon analysts. The scheme was cooked up in concert with the German finance ministry and had the full support of Chancellor Angela Merkel. I heard a top German official say at a private dinner three weeks before the OMT that "nothing flies in the eurozone right now without Berlin's approval", and I have no doubt that he meant it. This is how EMU works. There is no sign yet that Mrs Merkel is ready for QE.
The ECB insists that the latest dip in inflation is due to falling energy costs, and therefore transient. It is a suspicious alibi. The ECB made the opposite case in 2008, raising rates into an oil shock on the grounds that energy effects are not transient.
In any case, some of the world's top energy analysts say oil has only just begun to fall as global crude production surges. Iraq's output has reached a 35-year high. Libya's exports are poised to soar as rebel militias end their blockade. The US may add 1m barrels a day this year, hitting 11m. A drop in oil prices to $80 would be a tonic for falling real incomes in half of Europe, but it would also unhinge "inflation expectations" altogether, the kind of rupture that hit Japan in the 1990s.
Europe's deflation scare will blow over if we really are on the cusp of a fresh cycle of global growth. Whether that is the case as the US and China tighten together remains to be seen. "We could be facing years of slow and subpar growth," said the IMF's Christine Lagarde this week.
"The risk is that without sufficient policy ambition, the world could fall into a medium-term low-growth trap. More monetary easing, including through unconventional measures, is needed in the euro area," she said.
We may even be nearing the end of a five-year global cycle, one that Euroland largely missed due to its own unforced errors. If so, the region is just one upset away from a lurch into full-blown deflation that must mathematically drive Italy and others into insolvency, precipitating a sovereign debt crisis too big to be contained. It is a policy choice. Twenty-four men and women with a will of their own are letting it happen.
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