Eurozone risks Japan-style deflation crisis
THE eurozone is one shock away from a Japan-style deflation crisis after a key measure of prices fell to the lowest since the launch of the single currency.
The region’s core inflation rate – which strips out food and energy – fell to 1pc in March. This is far below expectations and leaves monetary union with a diminishing safety buffer.
“The eurozone is tracking the experience in Japan in mid-1990s. there is a very high risk of a slide into deflation,” said Lars Christensen, a monetary theorist at Danske Bank.
While eurozone core inflation was slightly lower in the aftermath of the Lehman crisis, the current figure is distorted by the one-off effects of VAT increases and levies linked to austerity. Adjusting for these taxes, the rate is now running at 0.4pc.
“The European Central Bank [ECB] should be concerned. If there is another severe shock, the eurozone faces a much bigger risk of falling into a deflationary trap,” said Julian Callow, global strategist at Barclays. “The danger is when deflation combines with high debt and deleveraging and becomes toxic. That raises the risk of a debt-deflation spiral. There are already signs of this in southern Europe.”
Mr Callow said nominal GDP – tracked by monetarists as the key indicator in sovereign debt crises – fell 1.8pc in Spain and 1.2pc in Italy last year. This means that the debt burden is rising fast on a contracting base.
David Owen, from Jefferies Fixed Income, said the mix of falling inflation and an ageing population risks pulling the eurozone into a “liquidity trap” where the self-correcting mechanisms of the economy break down. “This looks strikingly similar to Japan 15 or so years ago,” he said.
Mr Owen said the ECB cannot just “sit back and do nothing this week” at its meeting on Thursday, and may ultimately have to launch full-blown quantitative easing.
Most analysts expect the ECB to cut rates a quarter point to 0.5pc but there is broad consent that this will do little to alleviate the credit crunch for smaller firms in Spain, Italy and Portugal, where borrowing costs are two to three times higher than costs for North European rivals.
Data from the ECB show that the eurozone’s “broad” M3 money supply contracted in March, while private loans fell by 0.8pc. “The growth of money over the last three months has been very weak. The imbalance within EMU between Germany and the rest is intensifying,” said Tim Congdon from International Monetary Research.
Mr Christensen said the ECB may delay rate cuts this week to offset the retreat from fiscal austerity in Italy, Spain, France and the Netherlands, deeming their job to hold the feet of recalcitrant governments to the fire. “No doubt the Bundesbank is screaming about this,” he said.
Italy became the latest country to rebel against EMU policy regime this week when the new premier Enrico Letta lashed out at “death by austerity” and vowed to revoke a string of tax rises.
Mr Letta flew to Berlin on Tuesday to explain the country’s U-turn to German Chancellor Angela Merkel. She took a cautious line at the joint press conference, saying Italy had made “considerable” strides to reform its economy, but also said that “every country must play its part” in restoring order to the eurozone.
The greater rift is with Paris, after the French Socialist Party lashed out at the Chancellor in a vituperative attack, blaming the deep social and economic crisis in Europe on the “selfish intransigence of Mrs Merkel, who thinks of nothing but the deposits of German savers, the trade balance recorded by Berlin and her electoral future”.
The text was later modified to an attack on the “liberal politics of the German Right”, but the damage is already done. There has been an unprecedented breakdown in trust between EMU’s two core powers, and a split in core strategy that cannot easily be bridged.
The Free Democrat Party (FDP) in Mrs Merkel’s coalition has fanned the flames with a counter-attack, deriding France as a basket case with an economy in deep decline. It accused Paris of clinging to a coddled welfare model with a state sector near 56pc of GDP that is unfit for the rising challenge from China, India and the emerging world.
“France’s industry is losing competitiveness. Companies are continuing to relocate abroad. Corporate profit margins are thin,” said the internal party paper, sponsored by German vice-chancellor Phillip Rösler.
The report said France has the “highest tax and social security burden in the eurozone”, the “second-lowest annual working time” and soaring unit labour costs.
A second FDP report entitled "France: Europe’s biggest problem child" said the reforms of French president Francois Hollande were window-dressing.