Europe’s Deflation Challenge
Tuesday, October 29, 2013
In the wake of Europe’s longest postwar economic recession, the specter of deflation now haunts Greece, Ireland, Italy, Portugal, and Spain. Yet the European Central Bank (ECB) shows little sign of pursuing a more accommodative monetary policy that might address the European periphery’s deflation challenge. The inaction of the ECB, coupled with the complacency of European policymakers more generally, is regretful — if deflation does take hold in the European periphery, it will make the resolution of Europe’s ongoing sovereign debt crisis all the more difficult.
The latest European consumer price data leave little room for doubt that the European economy is already in a distinctly disinflationary process. According to Eurostat, overall European inflation has more than halved, from 2.6 percent for the year that ended in September 2012 to 1.1 percent for the year that ended in September 2013. More troubling yet, the latest inflation numbers indicate that consumer prices are now falling in Greece, while countries like Ireland, Portugal, and Spain are all now on the cusp of price deflation.
Consumer prices are now falling in Greece, while countries like Ireland, Portugal, and Spain are all now on the cusp of price deflation.
The rapid deceleration in European inflation is hardly surprising given the very large output and labor market gaps that presently characterize the European economy. Five years after the Lehman Brothers crisis, the European economy is yet to regain its pre-2008 output level, while overall European unemployment remains stuck at a record rate of 12 percent. Meanwhile, output gaps in countries like Italy and Spain are now well in excess of 10 percent and unemployment in the European periphery is considerably above the high European average.
The prospect for a further deceleration in European inflation is all too real given Europe’s weak economic outlook and the present strength of the euro. With countries in the European periphery still required to pursue budget austerity in the context of an ongoing domestic credit crunch, it is difficult to see how Europe can stage a strong economic recovery. And absent a strong recovery, one must expect that the European periphery will continue to be characterized by unusually large output and labor market gaps that will exert further significant downward pressure on wages and prices.
As the Japanese experience over the past two decades would attest, deflation can constitute the strongest of headwinds to economic recovery. Not only does it incentivize consumers to delay expenditures, it also has the effect of increasing the real burden of private sector debt and of raising the real cost of borrowing. This would seem to be the last thing that a struggling European economic periphery needs.
A particularly troublesome aspect of deflation in the European context is that it limits the ability of countries like Ireland, Italy, and Portugal to reduce their public debt burdens. These countries all have public debt ratios of around 125 percent of GDP and they still have budget deficits in excess of levels consistent with stabilizing those ratios. An anemic economic recovery at best, coupled with a move towards price deflation, raises the very real prospect of stagnating nominal GDP growth across the periphery. And such a prospect makes it difficult to see how the countries in the periphery can put their public debt on a more sustainable path.
Not only does deflation incentivize consumers to delay expenditures, it also has the effect of increasing the real burden of private sector debt and of raising the real cost of borrowing.
Overall European inflation is now at approximately half the ECB’s target rate of “close to but below 2 percent.” This makes it difficult to understand the ECB’s tardiness in further reducing its policy rate and in committing itself to maintain these policy rates at close to the zero bound for a considerable time period. This would seem to be the least that the ECB should do now, given the very real deflation risks in the periphery and the fact that large labor and output gaps are likely to persist in many euro area countries.
Equally difficult to understand is European policymakers’ seeming indifference to the credit crunch that continues to afflict the periphery and that persists in clouding the periphery’s chance for a meaningful economic recovery. Bank credit continues to decline at a significant pace in all of the peripheral countries, while those small- and medium-sized enterprises in the region that do have access to credit pay interest rates that substantially exceed those paid by enterprises in the European core countries.
Yet, despite the ECB’s recognition of the malfunctioning of its monetary transmission mechanism, the ECB has come up with no initiatives to address this problem. Worse yet, European policymakers seem unable to find the political will to move more rapidly to a banking union that might offer hope of finally ending the credit crunch.
Over the past year, the easy global liquidity conditions associated with quantitative easing in the United States have helped mask the ongoing public debt vulnerability in the European periphery. European policymakers should not count on those liquidity conditions persisting and should act while they can to get credit flowing again in the European periphery.
Desmond Lachman is a resident fellow at the American Enterprise Institute.
FURTHER READING: Lachman also writes “Europe the Morning After the German Elections,” “The European Central Bank’s Clay Feet,” “The ECB Delays at Europe’s Peril,” and “Will Europe Fix Its Banks in Time?” John H. Makin says “Forget Tapering, and Get Ready for QE4,” and “Bernanke Needs to Abandon Taper Talk.” James Pethokoukis blogs “Here’s What Happened When the ECB Did What Republicans Want the Fed to Do” and “Why, Exactly, Does the GOP Want the Fed to be More Like the ECB?”
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