Europe’s Deflation Paradox

Investors Chronicle, November 4, 2013. All Rights Reserved.

The news that euro area inflation fell to a four-year low of 0.7 per cent last month raises a paradox.

On the one hand, it’s widely agreed that such a rate is, as Societe Generale’s Michala Marcussen says, “uncomfortably low”. This is because it poses the risk of deflation – falling prices. And this could be a big problem. It would tighten monetary policy because falling prices mean a higher real interest rate. And if consumers expect deflation to last, they might postpone spending in the hope of picking up bargains later, and in doing so kill off the fragile recovery. Many economists therefore expect the ECB to react by cutting interest rates, possibly as soon as this week.

However, for the most stricken countries in the euro area, deflation is supposed to be a solution, not a problem. The reason for this is simple. The euro area’s crisis was due in large part to current account imbalances within the region, with the south borrowing heavily from the north. These occurred because southern economies lost price competitiveness against the north and so sucked in imports whilst exports faltered. For example, between 2000 and 2010 Germany’s relative unit labour costs fell by 11.7 per cent, whilst Portugal’s rose by 9.2 per cent and Greece’s by 22.5 per cent. As Jorg Bibow of New York’s Levy Economics Institute put it: “At the heart of today’s euro debt crisis is an intra-area balance of payments crisis caused by seriously unbalanced intra-area competitiveness positions.”

The official solution to these imbalances is for the south to cut wages relative to the north to restore competitiveness. The IMF is calling on Portugal to “reduce production costs” and Greece to use “wage adjustment” (a euphemism for cuts) to close the “competitiveness gap” with Germany. And – thanks to mass unemployment – they are doing just this. David Owen at Jefferies Fixed Income points out that hourly labour costs are falling in Greece and Portugal. And falling wages mean falling prices. In September, Greek consumer price inflation was minus one per cent, Portugal’s was 0.3 per cent and Spain’s 0.5 per cent.

This poses the question. How can deflation be a danger for the euro area as a whole, when it is supposed to be a solution for the south?

One could argue that the export and import sectors are a bigger fraction of GDP in individual countries than they are for the eurozone as a whole, and so improved competitiveness would do more to boost growth in Greece or Portugal than it would for the euro area as a whole. And one might add that investment is more sensitive to costs within the eurozone than it is between the eurozone and rest of the world, and so improved competitiveness would do more to attract inward investment into Greece or Portugal than it would into the euro area.

These, though, aren’t the whole story. As I argue elsewhere, it’s not at all certain that falling wages will be sufficient to turn around Greece and Portugal.

Instead, this paradox highlights a flaw within the euro area – that it contains a bias towards unemployment and deflation. In theory, Greek and Portuguese competitiveness could be improved not just by wage cuts there but by inflation (and higher demand) in the north. But this isn’t happening. Yes, German wages are rising. But only slowly. And it is still running a big external surplus which is, as the US Treasury recently said, creating “a deflationary bias for the euro area.”