EU Nations Teeter On the Edge of Deflation

EU Nations Teeter On the Edge of Deflation

September 12, 2014 | 1524 GMT

 

 

Analysis

During an Aug. 22 speech at the U.S. Federal Reserve’s annual conference in Jackson Hole, Wyoming, European Central Bank President Mario Draghi laid out the framework for a new plan to raise inflation and promote sustainable growth in Europe. He also implied that the austerity measures imposed during the European crisis have been ineffective. The idea behind austerity, which Germany strongly supported, was that tight restrictions on fiscal policy would reduce debt, and that low debt would in turn facilitate growth. Draghi’s speech seemed to align with an alternative view from southern Europe, which sees economic malaise as a byproduct of a lack of demand and not a preponderance of debt.

The departure may not be as radical as it first appears. For the past two years, the European Central Bank has been forced to take more unorthodox measures to counter dangerously low inflation rates — rates that are actually nearing deflation, which wrecks countries with high levels of debt. The prospect of even looser fiscal policies in the eurozone, such as higher taxes and spending, will worry Germany, which has a longstanding mistrust of eurozone largesse. However, Berlin would be even more hesitant to accept the other major option for stimulating demand: quantitative easing.

Another reason inflation is such a problem involves the relationships among eurozone members. The eurozone inflation rate has been dropping steadily ever since the euro crisis of 2012. Heavily indebted peripheral economies (France, Ireland, Italy and Spain) have a strong incentive to keep their inflation levels as high as possible, since high rates alleviate some of the pain of debt repayments.

Meanwhile, competitiveness relative to Germany has complicated the situation. Before the eurozone was created, countries became more competitive by devaluing their currency. But that was no longer possible once those countries entered a monetary union. Their only recourse was to keep inflation lower than that of the strongest country in the union: Germany, which keeps its unit costs extremely low largely through reforms undertaken at the beginning of the last decade. So as eurozone inflation fell, eurozone economies had a hard time remaining competitive without slipping into deflation. Now, very low inflation levels benefit no one, least of all the fragile economies that are trying to grow while managing their debt.