The demon called inflation may not be dead, but in Europe deflation may be coming to life

Posted: May 2, 2013 in Europe, Eurozone Economy, Inflation
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The inflation hawks say runaway inflation is inevitable. With record low interest rates and money printing, it is as sure as eggs are eggs.

If that is so, explain this. In the latest data out today from Eurostat, inflation in April was recorded at 1.2 per cent. That is about as alarming as one broken egg in a giant chicken farm.

The inflation rate has halved over the last year – it was 2.6 per cent in April 2012.

A breakdown of the figures is not yet available, but last month inflation in Greece was just 0.6 per cent. In Germany it was 2.0 per cent.

Truth be told, in order to compete, the countries of the southern Eurozone – that is Portugal, Spain, Italy and Greece – have to see prices fall relative to Germany.

This has already happened to an extent in Ireland. If you give the consumer price index in Germany and Ireland a reading of 100 in 2008, then by March this year the index had risen to 115 in Germany, 109.5 in Ireland. In other words, since 2008 German prices have risen by 15 per cent and by 9.5 per cent in Ireland. The economy of Ireland still has plenty of problems ahead, but it has at least partially closed the competitive gap with Germany.

The problem facing the southern Eurozone is that at a time when average inflation across the region is just 1.2 per cent, in order to close the competitive gap they may need to see even lower inflation than that – indeed outright deflation may be the ticket.

When you carry large debts, deflation is about as disastrous as you can get. Imagine the scenario. A country suffering from deflation may be growing in real terms, but in nominal terms contracting. And if nominal GDP is falling, it becomes devilishly difficult – some might say nigh on impossible – to cut debt relative to GDP.

Capital Economics reckons that as a result of deflation, there is a danger that by 2020 debt government debt in Italy and Greece may pass 200 per cent of GDP. And it could be around 170 per cent of GDP in Spain and Portugal. The very process of austerity, and the domination of hawks at the ECB, is creating low inflation across the Eurozone, which in turn may cause debts in Southern Europe to escalate to even more horrendous levels.

Capital Economics reckons there are three possible solutions: default, euro exit, or money transfers from north to south of the Eurozone – in other words, much closer political union.

Italy’s new Prime Minister Enrico Letta is pushing for the latter approach. In a speech yesterday he laid it on thick: “Our destiny as Europeans is common, otherwise it will be made up of individual countries that will slowly decline,” he said.

There is a fourth scenario, however and that is more inflation, especially wage inflation, in Germany,

EU Social Affairs Commissioner László Andor has called for wages to rise in Germany. In an interview with Süddeutsche Zeitung, he said: “Belgium and France have been complaining about German wage dumping.”

Mr Andor warned that the alternative to growth policies entailing rising wages in Germany – perhaps enforced by a rise in the minimum wage – may be mass migration.

In words that might resonate with many in the UK, he said: “Some people compare the situation to America in the 19th century, when there was a mass migration from the south to the prosperous north after the Civil War. In order to avoid this, it is necessary to create growth in the crisis countries.”

Whatever the solution, it is clear that deflation and not inflation is threatening to pulverise the southern Eurozone economy.

© Investment & Business News 2013

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