Deflation dangers in euro zone

The cover story in the latest issue of The Economist (25 October) dubs the coming of deflation dangers in the euro zone as the “world’s biggest economic problem”. Coupled with stagnation, deflation raises the spectre of a third recession in the euro zone in the last six years, and as The New York Times puts it, creates “a renewed existential crisis” for the bloc.

Annual inflation in euro zone was a meagre 0.3% in September, substantially below the European Central Bank (ECB)’s target rate of inflation of around 2%. Recent numbers suggest that in countries such as Greece, Italy and Spain the rise in headline as well as core consumer price index (CPI) has been negative. In 11 of the 18 countries in the euro zone, deflation has already set in, in terms of prices of goods, with inflation in services hovering around the 1% mark, on average. Given that the bloc accounts for about a fifth of the world gross domestic product (GDP), the slowdown of both output and prices in the euro zone could be a potential drag on global growth.

Why is the euro zone situation, facing the double dangers of stagnation and deflation, worrisome?

First, deflation is a symptom of very weak aggregate demand, and can generally lead to negative price expectations, bringing in a great amount of uncertainty in investment and consumption plans by firms and households. If prices continue to drop, households and firms would ideally want to postpone their consumption and investment plans, thereby contracting aggregate demand further—which is bad news for economic recovery. In turn, such secular stagnation may exacerbate the double-digit joblessness rate in the euro zone, currently around 11.5% as per the latest figures from Eurostat. In member-countries such as Greece and Spain, the last reported unemployment rate was around 27% and 24.4% respectively, with the jobless rate among youth above 50% in those countries. In such a scenario, we may possibly be looking at renewed protectionist and anti-globalization sentiments concerning the labour markets across the Euro zone countries—something which may not particularly be in our economic interest.

Second, so-called responsible fiscal policies (austerity measures and deficit targeting) undertaken by member-countries in the aftermath of the global financial crisis of 2008-09, guided by stability and growth pact rules in the bloc, meant that automatic stabilizers (lower taxes, higher transfers), which could have helped trigger the counter-cyclical adjustment process, were made dysfunctional. To maintain mandated deficit levels, countries in fact resorted to higher marginal tax rates, and lowered government spending. Such policies led to multiple-period negative demand shocks thereby acting as automatic destabilizers and worsening the contraction. There is little evidence to suggest that the lessons on how a banking and sovereign debt crisis catapulted into a full-blown growth crisis due to policy rigidity, has been learnt well. What is worrisome in the current period is that in the name of fiscal discipline, such rigidity continues. Germany, for example, has been opposing larger public spending plans of Italy and France for 2015, verdict on which by the European Commission is expected this week. Germany also neither appears to be heeding calls from other member-nations to shed its conservative fiscal policies, and increase public spending, particularly as its own output growth is contracting. Excessive austerity may not be very helpful, particularly when the deflationary gaps are increasing in the member-countries, and real and nominal wage stagnation does little to correct the gap.

Third, many euro zone countries are faced with a high debt burden, both private and public. Latest available data from Eurostat reports that the public debt of 18 nations reached around 91% of GDP at the end of 2013. The debt-to-GDP ratio in Greece and Italy is as high as 179% and 128% respectively. Such debts are going to grow in real terms in deflationary periods, thereby making it more difficult for governments (and households and firms) to reduce their debt burden. This may in fact compel the debtor governments to adopt greater spending cuts and/or increase marginal tax rates to be able to repay their debts (and remain solvent), thereby worsening the contraction in aggregate demand.

Fourth, deflation could render conventional expansionary monetary policy instruments quite ineffective. Nominal short-term interest rates are anyway close to zero in most countries in the bloc, and central banks cannot expect to set the real or inflation-adjusted interest rate any lower.

Coupled with such constraints, Germany (the largest country in the bloc) has been resisting ECB’s plan to adopt unconventional monetary policies—such as launching sovereign bond-purchasing programme a la quantitative easing programme in the US, which could potentially compensate for the negative multiplier effect of contractionary fiscal policies adopted by most countries in the bloc. This has also meant that the policy instruments available to address the slowdown and deflation have become even more limited. Recent data suggests that countries such as Poland, Britain and Sweden, which have remained out of the euro zone, and have been able to chart out their independent monetary policies, have in fact grown better than major economies in the euro area.

While whether a possible re-capitalization of euro zone banks, which failed ECB’s asset-quality review and stress test on Sunday, revives investor confidence or not needs to be seen, it is nevertheless imperative that policy conservatism (both fiscal and monetary), propagated and virtually thrust upon by bigger economies in the bloc needs to be abandoned. Else, we may be possibly looking at the disintegration of the bloc in the near future.

Amarendu Nandy is assistant professor at the Indian Institute of Management, Ranchi.

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