The spectre of deflation


Picture of Olli Rehn
Olli Rehn

Europe’s still nascent economic recovery is in danger. Badly damaged by the financial and debt crisis since 2008, the European economy was stabilised in 2010-12 following inevitable consolidations in public finances and decisive action in containing financial market turbulence. Subsequently it has been in recovery mode, and since spring 2013 returned to growth.

Challenges remain, especially high levels of unemployment in many countries. This is very worrying for social cohesion in Europe. And because the younger generation is the worst hit, it could seriously dent our growth potential for some time to come. We Europeans still have a fragmented financial system in which viable businesses, especially SMEs in some countries, find it very hard to obtain financing. Businesses and consumers also need affordable energy, while at the same time we must face up to the immense task of mitigating climate change and driving forward the use of renewable energy – the green economy is both a challenge and an opportunity.

But the most pressing concern is the way Europe’s fragile recovery is now haunted by the re-born ghost of old-school geopolitics, and by the scary spectre of deflation. There’s no need to dwell on theories of secular stagnation, no matter how fascinating and perhaps even useful they might be, since the two factors are enough to do damage on their own and also reinforce each other. The conflicts in the Middle East and the fallout from the war in Ukraine – and from Russia’s economic stagnation – are weakening investor confidence and so dampening economic activity, thus exacerbating deflationary pressures. These deflationary pressures are in turn further depressing economic activity in Europe and aggravating unemployment.

The most pressing concern is the way Europe’s fragile recovery is now haunted by the re-born ghost of old-school geopolitics, and by the scary spectre of deflation

This is the bleak economic and political picture that Europe’s policymakers face today. The recent sudden turn for the worse in the European economy calls for an equally rapid and effective reaction by policymakers, especially within the eurozone, if we are to optimise the economic policy mix.

To bring about recovery in the European economy it will be essential to step up economic reform and forcefully to increase the flow of credit to boost productive private and public investment. If not, eurozone policymakers will be taking a big risk of seeing recovery permanently derailed.

What, then, would be the most viable policy mix for boosting the eurozone economy’s rebalancing and recovery? And what could be the best way of avoiding the key European institutions finding themselves in the sort of cul-de-sac that in the past has too often characterised the eurozone’s crisis response?

The protracted recession and high levels of unemployment mean that in many parts of Europe everyone must now do whatever it takes to overcome the jobs crisis. All the EU institutions will need to work within their mandates but with the common goal of boosting sustainable growth and therefore employment.

The EU’s policy mix should be to reflect these goals better than is the case today. Monetary policy accommodates this and will need to go on doing so – and perhaps, if need be, become still more expansionary. As to fiscal policy, in the acute phase of debt crisis in 2010-11 frontloaded consolidation was necessary. But once credibility was built by 2012, consolidation has proceeded at a slower pace. Now the consistent consolidation of public finances should continue, focusing on the structural sustainability of public finances over the medium-term. The Stability and Growth Pact isn’t stupid, but it does entail considerable scope for judgement based on economic analysis, the way it is applied. On these grounds, deadline extensions to reduce fiscal deficits – injury time, if you like – has been granted already since 2012 to e.g. France, Spain, Belgium and the Netherlands.

Next, we must resolve the liquidity trap, especially that affecting both households and enterprises in southern Europe, to let credit flow and so facilitate economic growth. This will require, using all possible means at the disposal of EU institutions, including the European Central Bank’s policy instruments and those of the European Investment Bank, to boost private and public investment.

More often than not in the eurozone, the political economy has been the problem. The veto powers of individual member states in the intergovernmental system of the eurozone means that often it has been impossible to achieve optimal policy agreements on the first-best economic solution. Instead, policymakers have more often than not been forced to resort to second-best political solutions. This may have helped to contain the crisis, but not to beat it permanently. The story of the recently-created European stability mechanisms is a case in point, with the fragile European Financial Stability Facility (EFSF) turned into the sturdier European Stability Mechanism (ESM) after two years in 2012.

To bring about recovery in the European economy it will be essential to step up economic reform and forcefully to increase the flow of credit to boost productive private and public investment

The eurozone can no longer afford sub-optimal decision-making, and its policymakers must now seek genuinely first-best solutions if they are at last to overcome the crisis. That’s why it is vital to build a sturdy bridge between the North and the South, between creditors and debtors in surplus as well as deficit countries. It must also link countries in pressing need of reform, like France and Italy, and on the other hand central bankers suspicious of wasting monetary expansion. This should be pursued in the name of Europe’s common interest, so that everyone can benefit from a co-operative solution rather than divergent ones. To put it another way, we need to overcome John Maynard Keynes’ somewhat cynical observation at the time of the Bretton Woods conference: “For a creditor country, adjustment is voluntary; but for a debtor country, it is obligatory”. We must do better than that by ensuring that the creditor-debtor divide will not dominate Europe.

This calls, in essence, for a new pact on the pursuit of reform and the provision of credit among the eurozone countries and European institutions, and obviously including the European Central Bank. All this certainly calls for better policy coordination among the EU institutions and member states than has been the case so far. And it surely calls too for bold strategic direction from the incoming European Commission and the Eurogroup. Jean-Claude Juncker’s commission will therefore have the major task of pursuing just such a reform and credit pact.

The new pact should include three elements. First of all – as a necessary condition for other elements of the deal to have the intended positive impact – the countries that have for years delayed the necessary economic reforms now need to get into high gear. This especially means France and Italy, both great countries with plenty of entrepreneurial and innovative potential waiting to be put to more productive use. But unfortunately both have for years suffered from sluggish growth, lost competitiveness and reduced export market shares, and so have seen unemployment rise to intolerable levels. The same goes for my own native Finland, which is now undergoing severe industrial restructuring and has delayed critical structural reforms, and now suffers from stubbornly low growth and high unemployment.

In France, the recent government reshuffle has given President François Hollande and Prime Minister Manuel Valls the chance to make a new start on economic reforms based on the Responsibility and Solidarity Pact that has been pursued over the past year. This should yield far-reaching reforms to make the labour market more flexible in terms of pay and hours worked, and therefore more conducive for job creation. Another challenge is to make France’s pension system more sustainable and to maintain its commitment to the consolidation of public finances, in line with the expenditure review. France should also make strong efforts to restore the profitability of its enterprises, and thus their capacity to invest and create jobs.

In Italy, this means concluding the political and judicial reforms needed to make the country governable and its legal system effective, and that has rightly been the stated goal of Prime Minister Matteo Renzi. Italy’s unemployed would greatly benefit if Renzi were to use his formidable political capital to make labour market rules more flexible for the sake of job creation. He should do so instead of focusing on replacement activities like seeking further flexibility in the fiscal rules, as that would only add to Italy’s debt burden – currently 135% of GDP – without any real stimulus to growth.

If high fiscal deficits and high public debt were the guarantee of high rate of economic growth, then France and Italy should be the European champions in this prime economic sport! And Japan should be the world champion. But this is not the case.

The call for serious economic reforms isn’t just loose talk that is more theoretical than practiced. It is based on empirical evidence, and I am not referring only to Ireland or Latvia, which have reformed their economies successfully, even though some pundits have dismissed these achievements “because they are only small states”. Spain, for instance, reformed its previously very rigid and dualistic labour market in 2012, and has since seen a positive impact on new jobs supported by restored competitiveness and strong export growth. And that’s not to speak of Germany, the Netherlands, Denmark or Sweden at an earlier stage.

Second, once France and Italy have become serious about economic reform, then the ECB should without any unnecessary delay go all the way it needs to combat the deflationary spiral. Once the words that have been uttered by Renzi and Valls are turned into deeds, and their reforms really move forward, then the ECB’s Governing Council should be convinced of the positive impact of further monetary expansion on the so-called ‘monetary policy transmission mechanism’.

This would imply that the full effects of the ECB’s much-awaited more expansionary monetary policy and unconventional measures are effectively implemented and channelled through the banking system to businesses in need of credit for investment. This should particularly be the case of SMEs that are being starved of credit although they are the job creation and employment backbone of Europe.

One needs to realise that the profound problems facing France and Italy are mostly domestic in origin, and logically they have to be corrected by bold and consistent domestic reforms

In other words, apart from liquidity provisions to channel credit massively through the banks to the real economy by way of the ECB’s targeted long-term refinancing operations (= T-LTROs), the plan to purchase asset-backed securities of corporates, especially SMEs, is being implemented. Once its effects become known during the autumn, then the ECB will have to decide whether to engage in full-scale quantitative easing, which could imply, in line with the its own decision on the purchase of corporate securities and bonds, purchases in larger magnitude of private-sector covered bonds as well as in parallel buying government securities in proportion to each euro member’s share of ECB capital. In the current no growth context, it would only be no more than common sense to err on the side on monetary stimulus rather than that of caution.

That said, one needs to realise that the profound problems facing France and Italy are mostly domestic in origin, and logically they have to be corrected by bold and consistent domestic reforms. One of the (still tentative) lessons of Japan’s “Abenomics” is that monetary stimulus alone cannot lift a sclerotic economy unless profound structural reform is initiated and implemented before that, or at least in parallel.

European-level economic policies must support these countries’ efforts once they are convincingly serious about reform. This is particularly the case if – as empirical evidence now seems to show – we are experiencing a period of low inflation, if not outright deflation.

What, then, does recent empirical evidence tell us about the spectre of deflation? Consumer price inflation decreased substantially over the course of last year, particularly in the last quarter of 2013. This was partly due to external factors like lower energy and commodity prices, and partly due to domestic factors related to somewhat weaker wage pressures.

Price pressures have remained subdued as energy prices have continued to decline and as demand has only gradually firmed up. This is exacerbated by unemployment that is still high. Consumer price inflation has been very low over the past year, and according to Eurostat consumer prices rose just 0.3% this August. That’s obviously far below the ECB’s self-declared inflation target of “close to but below 2%”, which is considered to be the proxy of monetary stability. Still the ECB predicted in June that inflation would average 0.6% over the summer, so core inflation is clearly below the forecast path and, as ECB President Mario Draghi noted in his speech at Jackson Hole in August, the long-term inflation expectations have become much less strongly anchored than before.

What are the implications of all this, and why would a deflationary downward spiral be so damaging? From the consumer’s instinctive point of view, low inflation should support real incomes. But that is a deceptive argument because a prolonged period of very low inflation in the euro area, not to speak of outright deflation, would make the ongoing rebalancing of the European economy much more difficult.

Why? Although, it is only natural that inflation should be kept low in vulnerable reforming countries like Ireland, Spain, Portugal and Greece – and even Italy – because they are engaged in regaining cost and price competitiveness, a prolonged phase of low inflation in the entire euro area would make it much harder for the recovering crisis countries to achieve these objectives. That’s because the real exchange rate of the euro would stay high, and subsequently the efforts of the ex-crisis countries to restore their competitiveness would be suffocated by the overly slow growth in export demand. And even, because inflation expectations began to sag, real interest rates have since the autumn of 2013 actually risen, and that will negatively affect debt dynamics. High debt levels must of course be addressed, but first and foremost through responsible fiscal policies and growth-enhancing structural reforms.

In a nutshell, a prolonged period of low inflation must not be an excuse for failing to reform, but it would undoubtedly make rebalancing harder. Outright deflation would be even worse, and would be damaging for Europe as a whole. It will be far better for the ECB to act fast and forcefully than to wait because if necessary it’s so much easier to correct than to tackle the problem belatedly.

Needless to say, the ECB can, under such conditions use its powers and instruments to play a crucial role both in terms of conventional monetary policy and through unconventional market interventions. Some say that this kind of policy coordination would be against the independence of the ECB, and thus not in line with its mandate. I don’t agree; the EU treaty says the ECB’s task is to support sustainable economic growth and full employment so long as this doesn’t pose a threat to price stability – and that is of course not the case today. Smooth and effective policy coordination in an economic and monetary union cannot be in contradiction with the central bank’s independence. In any case, it is up to the Governing Council as the guardian of the ECB’s independence to decide. Better coordination, like the pact I’ve outlined here, is essential for EMU’s very survival and its future success, and that is a task very much at the heart of the ECB’s mandate and can even be said to be its core business.

Third, the surplus economies of the eurozone, particularly Germany, should further boost domestic demand and investment, both public and private, to support economic activity throughout the eurozone, as has for many years been advocated by the European Commission. Draghi’s very significant Jackson Hole speech, in which he called for a review of the eurozone fiscal stance as a whole, can be taken to mean that he has joined the calls for a stronger macroeconomic stimulus from Germany.

Germany should create the conditions for sustained wage growth, for example by reducing its high taxes and social security contributions, especially for low-wage earners and by addressing the problem of tax wedge. The federal republic should do more to stimulate competition in the services sector in construction and also for certain crafts and professional services – so as to boost domestic sources of growth. The participation rate of women in the labour force is lower than that of EU member states with comparable levels of economic and social development, like the Nordic countries, and should be enhanced by all-day schools and better day-care arrangements.

There are other pressing challenges too. Germany’s Energiewende requires an improved regulatory framework to unlock private investment in energy networks. And boosting investment in infrastructure would significantly help to sustain domestic demand in Germany, not just in the short term but in the longer term too through its positive impact on productivity. This sort of fiscal stimulus would be both cyclical and profoundly structural.

As the Bruegel think tank’s director, Guntram Wolff, has argued: “Ideally, the German inflation rate should move well above the 2% target that the ECB has set for the eurozone as a whole… Much of the weakness in public spending needs to be solved by more public investment in Germany”. All this would enhance Germany’s economic performance and welfare and could help reduce the inequalities that have accumulated in recent years. It would also have a significant positive impact on the whole eurozone economy. While increased demand in Germany might not lead directly to a large and immediate rise in exports from southern Europe, the reforms the European Commission has been advocating for Germany would facilitate a genuine and mutually beneficial rebalancing of the eurozone economy.

We must build the kind of Europe that opens up our citizens’ opportunities to innovate and create new businesses and therefore job

Crucially, a rise in domestic demand in Germany should help to reduce upward pressure on the real exchange rate of the euro or even bring it downwards, thus easing access to global markets for exporters in the eurozone periphery. To profit fully from this opportunity there should be no easing of the drive to boost competitiveness in southern Europe through structural reform.

Germany is, of course, not the only country whose policies have spillover effects on the rest of the eurozone. Together with France and Italy, these three largest economies hold the key to a return to growth and employment in Europe. If Germany can lift domestic demand and investment while France and Italy are embracing reforms to their labour markets, business environments and pension systems in support of their economic and industrial competitiveness, they will together do a great service to the entire eurozone.

Europe needs to work towards sustainable growth and job creation on all fronts. Moving from immediate firefighting to rebalancing and reform has been the changing focus of European economic policy over the past four years, and the shift from macro to micro will intensify. We must build the kind of Europe that opens up our citizens’ opportunities to innovate and create new businesses and therefore jobs. We must also aim at a Europe that seeks growth beyond its own borders through free-trade agreements, a Europe that combines entrepreneurial drive and a stability culture, a Europe where citizens and businesses can benefit from a genuine single market and a Europe that guarantees civil rights in the digital age.

Green growth is a case in point. The EU is still the global leader when it comes to fighting climate change, and by being both resource-efficient and cost-efficient we should turn that into a competitive advantage that delivers not only technological innovation but growth and jobs too.

The same goes for digital services and e-commerce. Businesses, especially SMEs, must be able to make their digital services available to all Europe’s 500 million consumers without artificial barriers. It is absurd that the free movement of goods, people and capital in Europe has been assumed for decades, yet bits and megabytes still too often are halted when commercially they are confronted by a national border.

This raises the wider issue of investment. The Banking Union is important to making the banks perform better, and thus helping sustainable growth. The repairing of Europe’s financial services sector must be completed to ensure that the banking sector is healthy and resilient and able to carry out its core task of lending to the real economy. That’s why the asset-quality review and stress tests conducted for the first time this year by the ECB are so important.

The green economy, e-commerce and SME lending should increasingly be the European Investment Bank’s focus of lending. It is the public development bank of the EU with a lending capacity that’s several times the size of the World Bank.

But the EIB has reached the limits of what it can do with its current capital base. Two years ago, on the Commission’s initiative, the EIB received a capital increase of €10bn, and is now implementing that. The consequence is that the EIB’s lending volume has increased by 40% annually for 2013-15, leading to overall investment of around €180bn over the three years, mainly targeted at innovation and infrastructure, renewable energy and the bio-economy as well as at SME lending. The Juncker Commission, which should take the initiative and deserves to be supported by the EU member states that govern the EIB, should at least double this and use the existing well-tested regime of EIB to channel the credit most effectively.

To save the fragile economic recovery in Europe that is at risk from prolonged low inflation and severe geopolitical tensions, we need a pact made-up of three policies and players – a kind of relance à trois. The key actors – Italy and France, the ECB and Germany – need to work out the details of such a pact this autumn and then agree on it at the European Council in December. This project should be initiated and facilitated by the incoming European Commission, for its three elements would reinforce each other. First, economic reforms in France and Italy could boost growth and reassure the ECB that its monetary stimulus would have the desired positive effect. Second, the ECB’s willingness to go all the way in monetary policy – up to a QE2 if needed – would help kill the spectre of deflation and justify both to the political leaders of France and Italy and their voters that the economic reform is worth the political cost. Third, a concrete signal by the German government that it will use its substantial fiscal space as Europe’s major surplus economy would have a significant impact on the European economy and an equal psychological impact on the European public. It would also help to convince France and Italy of the case for tough economic reform.

It is the best way of pursuing the common European interest and not giving in to national reflexes. It is time to move from words to deeds, and for all concerned finally to do whatever it takes to save Europe’s recovery.

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