Europe on verge of deflation

[rj1]

The European Central Bank yesterday surprised the markets with a rate cut to stave off the coming threat of deflation. The cuts have not saved Greece which is a lost cause at this point, as their statistics office measured their inflation rate to -1.9%. This is Depression-era economics, when you're heavily in debt and you're deflating, it means what you owe goes up even if you're making the payments. In Greece's case, it makes systematic default more likely which will carry on to everyone they owe money to. Other countries in the eurozone though tip-toeing above the deflation category, narrowly deflating, on the verge, or have incredibly low inflation rates.


Prompt action required on eurozone deflation - FT.com

Despite the promising title of this article - deflation IS likely to become the key issue confronting the ECB in the coming months - I have to admit to having been disappointed by the end product. The writer seems to be talking about a world which existed before the start of the crisis, using stereotypes that seem to show their age. For example.

"Within the very diverse monetary union Germany looks nothing like Japan did at the start of its long period of economic stagnation from 1990."

Right, Germany doesn't look like Japan in 1990, but it does look incredibly like Japan in 1997. The working age population is about to start to decline, there is a lot of debt still lingering in the banks that hasn't yet been cleaned up, and above all the economy is totally export dependent running a large current account surplus. Germany faces all the demographic challenges today that Japan did in 1997, which is actually when it really fell into deflation.

Germany is at risk of deflation today as the other Euro Area partners sink in. The Irish economist Philip Lane made the point at the start of the crisis that a short sharp deflation shock on the periphery might be no bad thing, since the deflation wouldn't necessarily become self-fulfilling as competitiveness would correct between countries and then the inflation rate would stabilise. Fair enough, but what he didn't consider, and I think we now should, was that THE PERIPHERY MIGHT DRAG GERMANY DOWN WITH IT.

What do I mean? That an ongoing drop in the price level on the periphery would force Germany to respond by also cutting costs in order that all the work they have recently generated didn't just move out to the periphery. There is no obvious win win dynamic from an internal Euro Area rebalancing due to the fact that the whole region is now ageing fast.

So you could end up getting a lose-lose dynamic where instead of a currency war between the various member states you get a price and wage cutting one. I mean, German domestic demand and inflation is not very strong at the best of times.

Here's another example of this old fashioned reasoning:

"That brings us to the heart of what is different about these two episodes. Any potential challenge from deflation in the eurozone lies primarily in Italy and the other peripheral countries. And the challenge is greatly exacerbated by the dynamic of a flawed monetary union. Just as a one-size-fits-all monetary policy gives an interest rate that is too low for Germany, it gives one that is too high for the weaker members of the eurozone."

Look, this problem is now beyond conventional monetary policy help. Going down to zero won't make any significant difference to the deflation dynamic on the periphery. This one size fits all argument belongs broadly to the pre crisis era, even if perhaps countries like France, Holland and Finland are still being kept afloat by low rates alone.

Then there's more:

"The eurozone countries with the biggest competitiveness problems have no exchange rate flexibility. They will have to address their cost disadvantage through internal devaluation. That is where the latest eurozone inflation numbers become disturbing, because it is much easier to reduce real wages if there is inflation. With deflation workers would have to accept falls in nominal wages. In unionised countries such as Italy this is unlikely to happen without considerable strife, if it happens at all."

Again, we are behind the curve. Italy is already having nominal wage cuts via labour force churn made possible through the labour market reform. Old workers leaving and younger ones being employed on newer less remunerative contracts. My sense is that this is now happening all along the periphery. Nominal wages (on aggregate) are now falling. That is precisely why the deflation is coming.

Only yesterday afternoon the head of Italy's business lobby Confindustria told Reuters that Italy is in a worrying "situation of deflation". "There is a very negative sign, and that is that despite the one point increase in VAT the latest data show inflation is falling. This means we are well and truly in a situation of deflation. It is worrying," Giorgio Squinzi told reporters.

Now back to the FT article:

"The eurozone is also in a less comfortable place than Japan in relation to government debt. Japan, as a big international creditor, has no need of external funds to finance its deficits..................... Because these countries have been forced into fiscal austerity and borrow at interest rates that exceed the growth rate of nominal GDP, public sector debt rises inexorably. Deflation would further increase that debt burden."

Well this is where we get to the heart of it. The Eurozone is now the biggest source of the CA surplus, since the periphery has now joined Germany in becoming export dependent for growth. This is what the US Treasury is kicking up all the fuss about. So together the Euro Area can finance, and this point won't be missed in countries like Italy and Spain. I expect the pressure for Japan style QE to become massive as the problem grows.

The two big questions about the future are:

Will Abenomics hold together long enough for it to still be seen as a plausible alternative?

Would Germany - in extremis - accept it. Which would be the worst scenario for Germany, accepting QE, or leaving the Euro?

[Noitartst]

Part of me welcomes economic chaos, truth be told--it keeps thing interesting, and it's hard to kick against the pricks. Things must come to a head to confront the welfare state's excess, and it could well be at hand. Hope it is.

[DOR]

Be careful what you wish for.

[Bigfella]

Part of me welcomes economic chaos, truth be told--it keeps thing interesting, and it's hard to kick against the pricks. Things must come to a head to confront the welfare state's excess, and it could well be at hand. Hope it is.

Yeah, the Great Depression & what it spawned was just a hoot.

[astralis]

it is absolute shocking how some people just don't learn from history.

“Liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate...it will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people!"

right.

[Doktor]

What happened after that?

[snapper]

An informative Q and A with the Torygraph's ultra dovish monetarist Ambrose Evans - Pritchard; Webchat: Are we entering the third phase of the Great Financial Crisis? - Telegraph

To sum up Ambrose case: The whole world needs more 'liquidity'.

Comment From Andrew Tollervey
If you ran the FED, BoE and ECB. What would you do on day one of your new job that helped all three?

Ambrose Evans-Pritchard:
Stay the course in the UK, freeze tapering in the US until "escape velocity" assured, launch Abenomics for Europe with €2 trillion QE immediately .. force German inflation to 4pc with relish.

He thinks the US 'recovery' is not as strong as it some think and would presumably reverse the Fed taper "What we have is G3 tightening into a very fragile global economy. The Fed and China are tightening a lot, but the ECB is tightening passively by letting its balance sheet shrink by €550bn in a year. All this is premised on a strong US recovery lifting the world. Well, it ain't happening. The US will muddle through, but the rest of the world can't afford the shock of tightening on every front."

Needless to say I disagree with this solution. All over the world since 2008 we have seen massive injections of 'liquidity' from fiscal stimulus to negative real term interest rates and the injection of $trillions of new 'magic money'. Not just in the US - which although we have discussed the US QE experiment most here has been relatively conservative compared to China or Japan. Even the eurozone have injected 'liquidity' in the form of LTRO 1 and 2. Italy did it again last week as we saw with rather shabby revaluation of the National Bank. Nobody ever payed enough attention as to how this might end - how could you turn off the tap? Well now we are seeing where all this cheap money went; some to the emerging markets on what they call the "carry trade" and a lot into the inflation of the equities markets. So you tighten monetary policy and expect nothing to change? It was never going to happen. Ambrose, who has always been pro QE, is now alarmed at the results of any attempt to turn of the money taps and in panic wants them turned back on... My view is the opposite; it should never have been started! It was blindingly obvious that supply $trillions of cheap money would create bubbles and losses would ensue when the policy was tightened and now he has the audacity to moan it. In effect his panic reaction to "moar QE" is a tacit admission that he doesn't and can never foresee and 'exit plan'. Those of us on our side of the debate have always argued that when the money taps (monetary and fiscal stimulus') stopped producing cheap money the real dangers would show. That is why I argued that US 'recovery' was not 'real', that in effect we have only covered up the underlying problems instead of dealing with them. Cheap money doesn't solve deficits and make inefficient business's suddenly efficient - it can at best buy time but instead of that time being used to address the real problems people were fooled into thinking that everything was recovering - after all the stock markets were doing great! No they weren't in the real sense; they were just inflating on 'magic money'. The re-adjustment to a post magic money world should never have had to happen if the politicians and the central banks had had the courage to deal with the real problems in 2008-9. They didn't and so when it does come it will be even more painful than it would have been then. There is no point moaning about the effects of an attempt to end QE for those who enthusiastically advocate it; 'twas always going to end this way. Adding 'moar QE' because you don't like what 'taper' is doing merely delays and makes even the worse the inevitable.

[Zinja]

Snapper,

I don't think QE was meant to solve underlying fundamental problems of 2008-9, rather it was meant to provide a soft landing to economies while they 'figure out' what hit them. The idea is once fundamentals have 'figured out', the button will be passed on and QE will slowly fade away.

[DOR]

It is going to be very hard to end QE while Congress remains on strike.

[JAD_333]

Right or wrong, Ambrose Evans-Pricthard looks to me like just another loud-mouth shockster who trades in audaciousness for a living.

[snapper]

Snapper,

I don't think QE was meant to solve underlying fundamental problems of 2008-9, rather it was meant to provide a soft landing to economies while they 'figure out' what hit them. The idea is once fundamentals have 'figured out', the button will be passed on and QE will slowly fade away.

What happened to the 'figuring out'? It got lost in the illusion of asset inflation based 'recovery'.

[Doktor]

Deflation, huh?

Isn't that simply solved by printing more money?

If ECB needs some advice how to solve this, former Yugo bankers are experts on how to create inflationary spiral.

[DOR]

The difference between QE and Yugoslavia, Zimbabwe and other examples of hyperinflation is that the former is not uncheck, irrational money supply inflation. QE has clear goals, specific targets that will lead to tapering, easing and reversal, and a credible agency behind it.

[Doktor]

Define credible agency. ECB looks like one. At least around here you can't find one more credible, anyway.

[snapper]

The difference between QE and Yugoslavia, Zimbabwe and other examples of hyperinflation is that the former is not uncheck, irrational money supply inflation. QE has clear goals, specific targets that will lead to tapering, easing and reversal, and a credible agency behind it.

Courtesy of the same apologists and robbers who brought you the greatest economic meltdown since the 1930's hit "Keynes plays numbers with lives" we bring the sensational sequal to "We know what we're doing 2008; No bubble here", the economically acclaimed and nominated for several Nobels "Robbing you for your own good". A hit on all families and welcomed by the wealthiest. Credible? You lost that in 2008 I would have thought. Yet you ask why central banks haven't been abolished and they insist they help prevent boom-bust! Incredible.