international analysis and commentary

Eurozone 2015: out of the deflationary abyss?


John Maynard Keynes once said, “…the oppression of the taxpayer for the enrichment of the rentier is the chief lasting result [of deflation]”. On January 7th the Eurozone tipped into deflation when it was announced by the European Central Bank that year-on-year prices had fallen by 0.2%. Now, the European Central Bank (ECB) has decided to use monetary policy to try and halt the slide by printing billions of extra euros as part of so-called quantitative easing (QE). Will these measures stop deflation?

The immediate impacts will probably have little effect on deflation. Although the stated aim is to stimulate the Eurozone economy the ECB’s announcement to inject €1.1 trillion into the Eurozone economy between March 2015 and end of September 2016 will probably at best stabilize the balance sheets of the Eurozone’s many still dodgy banks. ECB President Mario Draghi’s announcement suggested still little or no mutualization of sovereign debt which many of the southern European states are calling for. And, because the risk will be borne by national central banks rather than the ECB, the likelihood that the Eurozone just moved away – not towards – fiscal convergence raises a very serious question: why bother with a single currency at all?  Moreover, the QE that was injected into the UK and US economies was designed to address a cyclical downturn, whereas the Eurozone economies face structural weaknesses. Indeed, printing money may simply help these governments avoid painful reforms.

The key question is whether such stimulus will generate economic growth. Whilst some economists suggest that “temporary” factors (such as the collapse of oil prices, the already weakening euro and stable European consumer confidence) suggest this latest deflationary dip will also be temporary, other indicators suggest not. The Eurozone economy is bereft of economic growth (Italy has not grown since 1999), few of the vital structural political, economic and regulatory reforms necessary to render the single currency credible or the Eurozone economy world competitive have been made, there is over-reliance on Germany as the engine of growth, and both consumer and bond market confidence is fragile in the extreme. Moreover, Europeans are in this mess primarily because of the ridiculously optimistic political assumptions that were invested in the euro at its outset and the appalling governance of the single currency thereafter.

For all that something has to be done and Draghi is doing it. Indeed, for all the problems associated with QE the alternatives are probably far worse. Even the slightest shock could tip the Eurozone into a full-blown deflationary crisis that could in turn tip much of Europe into a full-blown depression. A trigger could come with the the fallout of the 25 January Greek elections and  the choices that the fiscally ill-disciplined SYRIZA party will now make.  It is that prospect which saw German Chancellor Angela Merkel scurry to London in early January for talks with David Cameron.  Even though the UK is outside the Eurozone such a crisis would need Europe’s two strongest economies to act closely together.  It would also need an awful lot more, which is why Europe needs a game-changer and useful though QE might prove in staving off disaster it is unlikely to work on its own.

In a 1933 Econometria article, economist Irvine Fisher established a proper understanding of the dangers of deflation. Entitled, The Debt-Deflation Theory of Great Depression, the article demonstrated just how dangerous structural deflation can be for both economies and societies. During a deflationary spiral, which the Eurozone is in or very close to entering, the value of assets and incomes shrink rapidly pushing up the real burden of personal and corporate debt. Soon debts can no longer be repaid which weakens vulnerable, debt-exposed banks – some of which suddenly collapse. Such a collapse effectively destroys confidence in the entire banking sector as investors and depositors rush to withdraw their cash and governments are forced to borrow and use the money of already hard-pressed taxpayers in an effort to prop up the banking sector. A bond market crash then ensues as the cost of government-borrowing soars and confidence further evaporates, leading in turn to emergency asset sales and the further driving down of confidence, hoarding and the effective end of normal economic activity with catastrophic social and political consequences.

The Eurozone today is full of individuals, corporations and governments with a high degree of personal debt. It is unlikely that Eurozone states would be able to stimulate or re-inflate the Eurozone economy as they are already dangerously indebted and their taxpayers effectively broke. In such circumstances only external help from the taxpayers of a rich, powerful state or other actors such as the International Monetary Fund or World Bank could help to stabilize the Eurozone economy. Such “help” would invariably come with political strings attached and calls for deep reform. The problem is that so many Eurozone societies have already been weakened by an economy now in its third recession in six years, that state institutions are possibly incapable of hard reforms for fear of social unrest.

The euro itself is central to the problem. Neither state nor super-state, the EU lacks both the political and economic cohesion and fiscal and economic discipline to apply even the limited instruments possessed by the ECB to effect. In the end, the taxpayers of the eight member-states that actually pay for the 28 member EU (led by Germany and to a significant extent Britain) are likely to be called upon to bail out the Eurozone by spreading the cost of Eurozone debt and by stimulating the economy through counter-deflationary/inflationary measures such as the printing of money.

The hope would be that the use of so-called Eurobonds and quantitative easing would help restore some semblance of economic confidence and all-important economic growth.  However, such is the fragility of the wider world economy, and the propensity for further geopolitical shock, the scale of the Eurozone debt mountain and resistance to reform in debtor states that any such stimulus by the “eight” would in effect have to be permanent.  This situation would quickly lead to the complete and irrevocable bankrupting of the creditor states, the final crash of the euro and with it the destruction of people’s hard-earned savings and pensions. In other words deflation and depression could lead to a first order European political disaster.

There are two immediate possible political steps that might buy European leaders some more time beyond the printing of money. First, much deeper integration of fiscal and monetary policy could be pursued by the Eurozone in parallel with the sharing of sovereign and bank debt across all Eurozone and/or all EU taxpayers. However, such a move would in effect entail the creation of a European super-state and almost certainly see Britain’s exit from the EU. Second, those economies which bear too high a level of debt and refuse or are unable to reform their inefficient economies could be cut free from the Eurozone. Greece is the obvious candidate. However, if a crash begins even Italy, Europe’s fourth largest economy, might be forced to exit the euro. That would either lead to a consolidated euro focused on north and western European economies or simply mark the end of the euro and with it Project Europe…or both.

What is needed is a game-changer that moves the Eurozone’s economic goalposts. Some economists believe a Transatlantic Trade and Investment Partnership (TTIP) with the US and Canada could boost trade and growth significantly. Indeed, whilst TTIP could never resolve the Eurozone’s many structural contradictions it could act like a kind of economic NATO affording collective economic defense to its members against the kind of speculations and panics that might trigger a great European depression.

TTIP would create a market of some 900 million people between the world’s most advanced economies and signal to the markets a willingness to take strategic steps to prevent deflation, TTIP could also help force Europeans to become more competitive and re-inject meaningful growth into Europe, although to do so would mean Europeans abandoning the expensive social models to which they are so attached and which renders Europe so uncompetitive.  Above all, TTIP would buy European leaders time to undertake the reforms vital to prevent a depression which they have singularly failed to do since the 2010 Eurozone crisis. Democracy? Well, European leaders have already in effect abandoned democracy as a form of government in favor of elite oligarchy.

There is of course at least one major caveat (and whole host of minor ones). For TTIP to be successfully concluded, American and Canadian politicians would need to be certain that they and their taxpayers are not being suckered into some kind of implicit, back-door Marshall Plan that would end up with them funding Eurozone debt. Equally, it is not in either the American or Canadian strategic or economic interest to see Europe fall prey to depression.

In an important article entitled A Comeback Strategy for Europe former Swedish Foreign Minister Carl Bildt and former EU foreign and security policy supremo and NATO Secretary-General Javier Solana Bildt called on Europeans to conclude a TTIP agreement quickly. Critically, the high-some twosome said, “…TTIP’s goal is to unleash the power of the transatlantic economy, which remains by far the world’s largest and wealthiest market, accounting for three-quarters of global financial activity and more than half of world trade.” However, Bildt and Solana contrasted the stalled TTIP talks with the progress being made in creating a Trans-Pacific Partnership or TPP and the very real danger of European economic decline in the absence of TTIP. They also gave a stark warning: “If the TTIP stalls or collapses while the TPP moves forward and succeeds, the global balance will tip strongly in Asia’s favor – and Europe will have few options if any for regaining its economic and geopolitical influence”.

Will Eurozone QE work? There will certainly be winners and losers. Asset prices will be supported for the rich but the modest savings of ordinary Europeans will take another hit. Indeed, Mario Draghi and the ECB seem to regard with contempt people who have worked hard to save money. It is also perhaps worth heeding the wise words of Zhau Xiaochauan, the Governor of the People’s Bank of China, “Monetary policy may create room, for a period, for other structural policies to come in, be implemented and do a good job. But monetary policy is not a panacea to reach a target”. That target is a fundamentally re-structured and reformed Eurozone economy open to the world and bereft at last of inefficient vested interests. Do not hold your breath.