Europe repeating all the errors of Japan as deflation draws closer
The whole eurozone must have a higher inflation rate to lift the South far enough above the deflation line to gain breathing room
By Ambrose Evans-Pritchard
9:13PM GMT 04 Dec 2013
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Europe is one shock away from a deflation trap. A surprise anywhere in the world is all that it needs: an upset in China as the credit bubble pops, or a global bond shock as the US Federal Reserve winds down monetary stimulus.
Producer price inflation (PPI) fell to -1.4pc in the eurozone in October. This is how deflation becomes lodged in the price chain.
"Prices are sticky for a while as you approach zero inflation, but once you break through the ice into deflation things can move fast, as we've seen in Greece," said Julian Callow, global strategist at Barclays. "The European Central Bank needs to act before the horse has already bolted."
Mr Callow said excess industrial plant in China is exporting deflation across the world. China's fixed capital investment over the past year has been $4 trillion, compared with $3 trillion for the entire EU and $3 trillion for the US. This has grown eightfold in a decade. It is a vast new source of supply for a saturated global economy.
China itself is now in PPI deflation. Factory gate prices fell 1.5pc in October. This has the makings of an almighty profits squeeze since wages have risen 13.6pc over the same period. There is a school of thought that China's investment glut will prove very hard to manage and this will trigger the next big round of angst in the world economy, but exactly when this will happen is anybody's guess.
Europe's slide towards deflation is replicating what happened in Japan in the 1990s at the onset of its lost decade, when trouble crept up on the country unawares. Near zero inflation seemed harmless until world events suddenly intruded: the Russian default and the East Asian crisis of 1998, the dotcom bust in 2001-2002.
The Bank of Japan's paralysis seems extraordinary to us now, and so do the arguments made by the governors of the day, Masaru Hayami and Toshihiko Fukui. Mr Hayami almost seemed to welcome deflation, thinking that it would force the political class to ram through root-and-branch reform, although it did no such thing. "I am not worried about the fall in prices," he said famously in January 2001.
Mr Fukui even said rising unemployment was a "good thing". It would hold political feet to the fire. The details are recounted in "Princes of the Yen" by professor Richard Werner, now at Southampton University.
The result of tight money was that fiscal policy had to carry the entire burden instead. Budget deficits exploded as Japan battled the slump. Public debt ballooned to 245pc of GDP. "Their behaviour was shocking, and the Europeans are now making the same mistakes," said Prof Werner.
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Put crudely, the EMU debt crisis strategy is to switch stimulus on and off for political purposes, tightening the screw on recalcitrant countries. The vogue term for this is the Nash Equilibrium, "game theory" doctrines that have so corrupted economics.
The trouble with the Byzantine politics of the eurozone is that you never quite know why people are pushing different agendas. Nothing is what ever seems to be, and economics has little to do with it.
Is this Nash strategy simply a cover for creditor enforcement of its own narrow interest? Or intellectual varnish for what is really a set of cultural tastes? Or Calvinist beliefs, a deeply-held assumption that pain is somehow cleansing - the "haunting fear that someone, somewhere, may be happy", to borrow the immortal words of HL Mencken?
The ECB has been roped into this game, writing secret letters to Italian and Spanish leaders dictating detailed changes in labour law and such matters. It has no mandate to act in this fashion, and certainly has no delegated authority from any elected parliament to serve as enforcer.
Monetary stimulus is being withheld because it might help slackers off the hook - the definition of slacking determined by a tiny cell in the German finance ministry - even when needed to cushion fiscal austerity.
This pollution of monetary policy is a key reason why the ECB has let M3 money growth fall to 1.4pc, disastrously undershooting its 4.5pc target, and why it has let inflation drop to near zero on a six-month basis. It is not true that the ECB is a replica of the old Bundesbank. The Bundesbank would never have let M3 growth fall so low for so long in Germany during the D-Mark era.
Since April, prices (adjusted for taxes) have fallen in Greece, Italy, Netherlands, Portugal, Slovenia and Slovakia, as well as the non-EMU group of Bulgaria, the Czech Republic, Latvia, Lithuania, Hungary and Romania. Prices have been falling in Spain since May, in France since June and even in Germany over the past three months.
"It is past time to recognise the deflation danger facing Europe," said Jean Pisani-Ferry, head of French policy planning in Paris. The ECB should stop kowtowing to "policy hawks" and deliver on its mandate. "The ECB must be prepared to make that choice," he said, echoing a view that is taking hold in the French establishment.
The ECB's Mario Draghi undoubtedly shares this view. He told an audience of very suspicious officials in Berlin two weeks ago that the bank had been forced to cut rates to a record low of 0.25pc to ensure a “safety margin against deflationary risks”, although everybody in the room knew that the two German ECB members had voted against it. He also warned that if inflation is allowed drift too low it becomes "much harder" for the Club Med states to claw back competitiveness under internal devaluations. "Adjustment runs into major head winds as demand suffers and real debt burdens rise,” he said.
This is the nub of the matter. If Club Med states have to deflate, their debt trajectories risk spinning out control. The two policy objectives of EMU crisis strategy are in contradiction, as the OECD spelled out last month.
Falling nominal GDP means the debt burden is rising on a shrinking base. The "denominator effect" is deadly when the public/private debt stock is high: 276pc in Italy, 300pc in Greece, 330pc in Spain and 389pc in Portugal. It is why Italy's public debt has jumped from 119pc to 133pc GDP in just over two years despite draconian austerity and a primary budget surplus.
Ebrahim Rahbari from Citigroup said the policy is pushing the South into debt-deflation and is likely to prove self-defeating. Officials in Brussels and Berlin are counting on exports to rescue Club Med, but Mr Rahbari says the ratio of exports to GDP is just 34pc for Spain and 30pc for Italy, giving them too little gearing.
These countries now face another problem as the euro grinds higher. More than half their sales go outside the eurozone, mostly on thin margins. A 6pc rise in the exchange rate this year is eclipsing any gains from cuts in unit labour costs. They face a Sisyphean task.
It is far from clear in any case whether the feat of closing the current deficit in Spain, Portugal and Greece is meaningful given the levels of mass unemployment, which erodes labour skills through "hysteresis" and therefore lowers the long-term economic growth rate, and that in turn makes it harder to tackle the debt mountain.
A case can be made that the hysteresis damage of EMU policies is greater than the benefits of reform. If so, it is a brutishly stupid policy as well as causing great suffering. German Chancellor Gerhard Schroder said he needed to let the budget deficit rise for a while to cushion the effects of his Hartz IV reforms.
The only way for Europe to break out of this trap is to lift the South far enough above the deflation line to gain breathing room. The whole eurozone must have a higher inflation rate.
Fabio Bassi from JP Morgan says the ECB will surprise everybody, proving just as aggressive in fighting deflation as it was in fighting inflation. Let us hope so, but I doubt that any of the measures now being floated will make much difference. A cut in deposit rate or another burst of lending to banks will not boost the M3 money supply.
The ECB has been behind the curve for most of the past three years, needlessly causing a double-dip recession that caused havoc to public finances, and too late at every stage since, despite the heroic efforts of Mr Draghi. It may now take full-blown quantitative easing to head off deflation, with bond purchases across the board. There is no chance of this before the German constitutional court rules on the legality of emergency measures next year, and little chance after that.
Almost nobody is making the case for QE in the German press, economics profession or policy circles. It is view as anathema across the political spectrum. Yet to push it through against German protest would set off a political firestorm. We are moving nearer to the final battle for control of EMU where there can be no compromise.
