BEFORE the fiscal and monetary stimulus of “Abenomics”, Japan was afflicted with a chronic economic sickness. Crippled by excess private sector savings, it fell into deflation in the 1990s, despite very low nominal interest rates. Today, it is often suggested that the Eurozone is experiencing a similar malaise.
Prior to the autumn, the leaders of the Eurozone had developed a sanguine view that the euro area was on the mend to a full recovery. Cheered by Mario Draghi, the president of the European Central Bank (ECB), promising to do “whatever it takes” to save the euro, confidence had seeped back into the continent.
Recent figures, however, have shown that German growth has stumbled, and the Eurozone is on the verge of entering its third recession in six years. Indeed, the Eurozone’s overall inflation rate has slipped to 0.4 per cent, albeit up from lows of 0.3 per cent in September, and there is a chance that it will further decline next year. A region that makes up almost a fifth of world output remains crippled by stagnation and deflation. Europe is not in good shape.
Is the Eurozone doomed? Reminiscent of Japan’s “lost decade”, the single currency bloc is suffering from an excess of private sector savings, and this is leading to an external surplus – despite the fiscal deficit. And like Japan in the 1990s, the Eurozone is also experiencing the combination of a low level of inflation alongside expansionary monetary policy and low nominal interest rates.
But there are crucial differences. In pre-Abenomics Japan, low inflation was explained by an abnormal distortion of income distribution. In the Eurozone, however, low inflation is explained by unemployment – and, therefore, by the weakness of wages and the improvement in competitiveness. Since 2013, the low level of inflation has, in fact, boosted real wages and made real interest rates acceptable for lenders, thus stabilising the Eurozone’s monetary situation.
But there are other, less happy, differences. Unlike Japan, which has a homogenous society, the Eurozone will not be able to hang together through years of Eurosclerosis and falling prices. As debt burdens soar from Italy to Greece, investors will become wary, populist politicians will gain ground, and – sooner rather than later – the integrity of the euro will once again be challenged.
What should the ECB do? It would do better to give up. Officially, the central bank has the objective of gradually returning Eurozone inflation to close to 2 per cent. But this objective is proving to be difficult, if not impossible, due to – first – the decline in commodity prices linked to the sluggishness of global growth, and – second – ongoing private sector deleveraging in the Eurozone.
If the ECB persists with its intention of restoring inflation to 2 per cent, the result of an increasingly expansionary monetary policy will be a very steep depreciation of the euro. This will be good for exporters, but it is worth remembering that this will act as a tax on consumers, hitting demand even more. Furthermore, it will exaggerate financial market anomalies: zero or negative interest rates, squeezing of risk premia, and distortions between the price of assets.
It would be reasonable for the ECB to keep policy as it is.
The future, however, is not bright. Many Europeans have been brought up to fear inflation, yet deflation can be more savage. In France, deflation is already taking grip. Since the beginning of the 2000s, the industrial value-added deflator has declined, whereas unit labour costs have inched up. This, in turn, has squeezed profit margins in industry. And if buyers expect prices to fall, they stop spending – sinking demand and spiking loan defaults. That was what happened in the Great Depression, with especially dire consequences for Germany.
Signs of stress are beginning to appear in both the markets and – more worryingly – in politics. Indeed, this is not just a matter of economics. As Draghi stated, “we need action on both sides of the economy: aggregate demand policies have to be accompanied by national structural policies”. Without a new push from the continent’s political leaders, growth will not revive and deflation could take hold.
Japan suffered a decade of lost growth in the 1990s and is still struggling. But unlike Japan, Europe is not a single cohesive country. And if this currency union brings nothing but stagnation, joblessness and deflation, then time is running out before members start voting to leave the euro: a risk that is rising all the time.
Patrick Artus is chief economist at Natixis.