Now that German growth has stumbled, the euro area is on the verge of tipping into its third recession in six years. Its leaders have squandered two years of respite, granted by the pledge of Mario Draghi, the European Central Bank’s president, to do “whatever it takes” to save the single currency. The French and the Italians have dodged structural reforms, while the Germans have insisted on too much austerity. Prices are falling in eight European countries. The zone’s overall inflation rate has slipped to 0.3% and may well go into outright decline next year. A region that makes up almost a fifth of world output is marching towards stagnation and deflation.
Optimists, both inside and outside Europe, often cite the example of Japan. It fell into deflation in the late-1990s, with unpleasant but not apocalyptic consequences for both itself and the world economy. But the euro zone poses far greater risks. Unlike Japan, the euro zone is not an isolated case: from China to America inflation is worryingly low, and slipping. And, unlike Japan, which has a homogenous, stoic society, the euro area cannot hang together through years of economic sclerosis and falling prices. As debt burdens soar from Italy to Greece, investors will take fright, populist politicians will gain ground, and—sooner rather than later—the euro will collapse.
This parrot has ceased to be
Although many Europeans, especially the Germans, have been brought up to fear inflation, deflation can be still more savage (see article). If people and firms expect prices to fall, they stop spending, and as demand sinks, loan defaults rise. That was what happened in the Great Depression, with especially dire consequences in Germany in the early 1930s.
So it is worrying that, of the 46 countries whose central banks target inflation, 30 are below their target. Some price falls are welcome. Tumbling oil prices, in particular, have given consumers’ incomes a boost (see article). But slowing prices and stagnant wages owe more to weak demand in the economy and roughly 45m workers are jobless in the rich OECD countries. Investors are starting to expect lower inflation even in economies, such as America’s, that are growing at reasonable rates. Worse, short-term interest rates are close to zero in many economies, so central banks cannot cut them to boost spending. The only ammunition comes from quantitative easing and other forms of printing money.
The global lowflation threat is a good reason for most central banks to keep monetary policy loose. It is also, in the longer term, a prompt to look at revising inflation targets a shade upwards. But the immediate problem is the euro area.
Continental Europe’s economy has plenty of big underlying weaknesses, from poor demography to heavy debt and sclerotic labour markets. But it has also made enormous policy mistakes. France, Italy and Germany have all eschewed growth-enhancing structural reforms. The euro zone is particularly vulnerable to deflation because of Germany’s insistence on too much fiscal austerity and the ECB’s timidity. Even now, with economies contracting, Germany is still obsessed with deficit reduction for all governments, while its opposition to monetary easing has meant that the ECB, to the obvious despair of Mr Draghi, has done far less than other big central banks in terms of quantitative easing (notwithstanding this week’s move to start buying “covered bonds”).
If there was ever logic to this incrementalism, it has run out. As budgets shrink and the ECB struggles to convince people that it can stop prices slipping, a descent into deflation seems all too probable. Signs of stress are beginning to appear in both the markets and politics. Bond yields in Greece have risen sharply, as support for the left-wing Syriza party has surged (see article). France and Germany are trading rhetorical blows over a new budget proposal coming out of Paris.
Joining the bleedin’ choir invisible
If Europe is to stop its economy getting worse, it will have to stop its self-destructive behaviour. The ECB needs to start buying sovereign bonds. Germany’s chancellor, Angela Merkel, should allow France and Italy to slow the pace of their fiscal cuts; in return, those countries should accelerate structural reforms. Germany, which can borrow money at negative real interest rates, could spend more building infrastructure at home.
That would help, but not be enough. It is a bit like the early years of the euro debacle, before Mr Draghi’s whatever-it-takes pledge, when half-solutions only fed the crisis. Something radical is needed. The hitch is that European law bans many textbook solutions, such as ECB purchases of newly issued government bonds. The best legal option is to couple a dramatic increase in infrastructure spending with bond-buying by the ECB. Thus the European Investment Bank could launch a big (say €300 billion, or $383 billion) expansion in investments such as faster cross-border rail links or more integrated electricity grids—and raise the money by issuing bonds, which the ECB could buy in the secondary market. Another possibility would be to redefine the EU’s deficit rules to exclude investment spending, which would allow governments to run bigger deficits, again with the ECB providing a backstop.
Behind all this sits a problem of political will (see article). Mrs Merkel and the Germans seem prepared to take action only when the single currency is on the verge of catastrophe. Throughout Europe people are hurting—in Italy and Spain youth unemployment is above 40%. Voters vented their fury with the established order in the EU’s parliamentary elections earlier this summer, and got very little change. Another descent into the abyss will test their patience. And once deflation has an economy in its jaws, it is very hard to shake off. Europe’s leaders are running out of time.