Relief that the eurozone has finally exited recession has come with strong gains in equity markets across the region.
After six consecutive quarters of declining output, investors are right to see some light on the horizon. They are also rightly impressed by the sheer scale of the economic adjustments that most of the crisis economies have achieved.
What could spoil the party? Many point to the low level of corporate lending and the challenge of getting credit to small and medium-sized enterprises in the peripheral countries. There’s also concern about the impact that Federal Reserve (Fed) tapering might have on long-term borrowing rates in Europe, and what that might do to growth.
Those are important worries – though the effect of tapering on Europe has probably been overstated. But one danger that investors should perhaps worry more about is that of deflation. That’s because very low – or negative – rates of inflation make it much harder for the peripheral economies to get a handle on their debt or achieve self-sustaining growth.
In October 2013 the eurozone inflation rate was 0.7 per cent – the lowest in four years. Most forecasters expect eurozone inflation to be below 1 per cent for much of 2014, and tend also to think that the risks are on the downside. In that kind of environment, it would be quite possible for inflation on the periphery to dip into negative territory, even if prices were rising in the area as a whole.
Greece and Cyprus have been living with falling prices for some time, and the Irish inflation rate has been hovering around zero for several months. Spain’s inflation rate was also zero in October 2013, while Italy’s has fallen from 2.8 per cent to 0.8 per cent in the space of a year.
You might say that low – or negative – inflation in these economies was a good thing. Isn’t it part of the necessary restructuring of these economies that they squeeze domestic prices and wages to rebuild their competitiveness? The answer to that is yes. But clearly there is a downside to all that restructuring in the form of shrinking domestic demand.
By 2014, Greek real wages will have fallen by more than 20 per cent since 2009, and Spain’s productivity has risen by more than 9 per cent since the start of the crisis, while Spain has got rid of a 10 per cent GDP current account deficit in just five years. In 2014, the Organisation for Economic Co-operation and Development expects the country to run a current account surplus of 1.6 per cent of GDP.
The problem – some would say, the tragedy – for crisis-hit eurozone economies is that this ‘internal devaluation’ has happened as governments have been desperately trying to stabilise their debts. A lower rate of domestic inflation might help raise competitiveness, but it makes the deleveraging job all the harder.
The UK has had the feeblest of recoveries since the onset of the crisis. But unlike most advanced economies, it has also seen a sustained period of inflation.
