In the latter half of 2013 there was growing optimism that the worst of the eurozone crisis had passed. Technical recession in the region ended in the third quarter and a more upbeat tone prevailed over both sovereign debt risks and the banking crisis as eurozone periphery yields continued to edge down. The compromises that are forging the EU banking union have helped, at least to date. The European Central Bank has provided a further tonic with a brace of rate cuts. Political risks have faded – at least until elections to the European parliament loom in May.
It is, though, difficult to approach 2014 with optimism for the eurozone. Many governments eased back on austerity in the middle of 2013, encouraged by the window created by the German election. But private-sector final demand is still stagnant everywhere bar Germany. The dearth of investment remains most troubling. Such an environment can only accelerate disinflation.
Credit is still contracting and M3 growth has slumped to just 1%, compared with the 4.5% rate the ECB deems consistent with its price-stability mandate. Average inflation in the distressed peripheral eurozone economies has fallen to zero. The south of Europe is in a debt deflation. With no inflation, nominal GDP growth is not high enough to cover debt servicing costs, so public-debt-to-GDP ratios will continue to rise.
Greece is in by far the worst position. Austerity has brought the budget back to primary balance. But it has crushed the economy. With deflation now approaching 3% and growth unlikely even to scrape into positive territory in real terms in 2014, the overall debt burden will jump despite the primary budget surplus. A simple example can illustrate this. Assume that Greek deflation continues at 2%. Assume also that the government maintains a primary surplus of 1.5% of GDP for 2013 and real GDP growth hovers around 1.5%. Then the debt burden will still exceed 215% of GDP in 2020, not far from double the EU Troika’s 124% target. The OECD is slightly closer to the mark, seeing debt at 160%, although its forecasts on deflation also understate this danger. Greece’s problem might be one of the more extreme, but its predicament applies to some degree across the periphery.
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Improved competitiveness is the key to raising long-term growth prospects, without which debt will become unsustainable. One way to boost competitiveness is by relative price falls in the periphery relative to the core and other trading partners. In practice, this means falling relative labour costs. This is easier during periods of modest inflation, when a lower nominal rate of positive growth in, say, Portuguese or Italian wages can close the competitiveness gap with Germany. But introduce deflation and nominal wages have to fall in the periphery. In an area with massive unemployment and where up to one out of two young people can’t find jobs, that’s political dynamite.
Relative price changes between the stronger and weaker economies help rebalancing when, say, eurozone inflation is running at 2% and Germany and the core at 3% to 3.5%. This does not work when the eurozone is in deflation or even at sub-1% inflation rates. That sort of eurozone inflation rate simply exacerbates peripheral debt sustainability, pressuring nominal GDP, interest rates and the overall debt burden with it.
The danger of debt deflation does not seem to be taken seriously by the ECB. The ECB justifiably wants to break the sovereign/bank debt nexus. But it also needs to increase the flow of credit to the private sector. The ECB’s reluctance to pursue unconventional policies (such as quantitative easing), embraced by other central banks, creates new challenges with rates bumping into the zero bound. As we’ve learnt from Japan, once deflation becomes entrenched, it is difficult to dislodge. A mildly negative deposit rate or trimming the refi rate a little closer to its floor isn’t going to work.
So where is the escape valve? It is the euro exchange rate. A cheaper currency would help address that and help with the peripherals’ competitiveness. That’s the only way to avoid the consequences of a deflationary Europe in 2014.