Deflation threatens to derail Euro recovery

Almost six years after the economic crisis began, Europe cannot afford to face into a prolonged period of stagnation

Arriving in Brussels last Saturday ahead of a summit to choose the next head of the European Council, Taoiseach Enda Kenny was unequivocal about the main challenge facing the next leaders of the European Union – the economy.

"Whoever takes up the presidency of the council is faced with the enormous prospect of dealing with the future economic strength and development of the European Union," the Taoiseach said, adding that unemployment was the "central issue" facing Europe over the coming years.

The continuing diplomatic crisis with Russia over Ukraine, a possible British exit from the European Union and worries about energy security and climate change policy may be some of the main challenges facing the new European Commission and Council which takes up office by the end of the end of the year, but last weekend it was the precarious economic situation that was to the forefront of leaders' minds.

EU leaders returned from the summer break to face an increasingly bleak economic picture. A swathe of economic figures over the summer has sparked serious concerns about the health of the euro zone economy, with the threat of further sanctions on Russia likely to exacerbate the situation.


In August, data for the second quarter of the year showed that, exactly one year after the euro zone economy triumphantly returned to growth in the second quarter of 2013, GDP growth stalled at 0.7 per cent. Most significantly, the bloc's three largest economies, Germany, France and Italy, experienced a slump, with German GDP contracting by 0.2 per cent.

Inflation figures

Manufacturing figures this week revealed a sharp slowdown in activity across the euro zone, with PMI falling to 50.7, the lowest reading in more than a year. Again, the euro zone’s largest and strongest economy, Germany, registered a slowdown in activity, with


, and particularly


, spurring ahead.

The services sector is also struggling, with growth in August the slowest of any month this year across the euro zone.

Perhaps most significantly, euro zone inflation figures continued to sound alarm bells, with inflation falling last month to a five-year low of 0.3 per cent.

With inflation now entrenched well below the ECB’s target of keeping euro area “close to but below” 2 per cent, the trend of low inflation has now emerged as a serious, long-term trend within the euro zone economy, generating fears that the bloc could be facing a deflationary period.

One of the salient factors about the figures has been the strong performance of so-called peripheral economies, such as Greece, Portugal and Ireland. The fact that the very countries which found themselves at the heart of the euro zone debt crisis are now enjoying robust growth reveals an irony – those countries forced to implement tough economic measures by a troika of lenders have successfully implemented change, while larger countries, which did not have the pressure of the IMF or EU troika inspectors, have failed to do so.

Viewed another way, over the past 18 months, the euro zone economy has emerged from a crisis situation, when the threat of a sovereign default and euro zone break-up was a real possibility, and entered a more deep-seated, and potentially prolonged, period of low inflation, growth and stubbornly high unemployment.

While the British and US economies are back in growth mode, the euro zone has slumped into stagnation and hovers perilously close to deflation.

Many see the recent data as a blip for Germany, which has consistently outperformed its euro zone peers, though the export-dependent nature of Germany’s economic model leaves it vulnerable to international market weaknesses, both in terms of its exports to Russia and further afield.

But the real concerns centre around France and Italy, the bloc’s second and third-largest economies, which have continually struggled to meet fiscal targets set by Brussels, or implement politically-unpalatable structural reforms. Italy, in particular, has one of the largest debt-to-GDP ratios in the euro zone.

Greater flexibility

Unsurprisingly, the slow pace of Europe’s economic recovery following the years of the sovereign debt crisis has once again raised the


versus growth debate.

Matteo Renzi, Italy's prime minister elected in February, and the country's fourth premier in just over three years, has led the charge in calling for a reassessment of euro zone economic policy, using the start of the Italian presidency of the EU Council in July to call for greater flexibility in the Stability and Growth Pact.

The timing of his intervention – as the European Union prepared to elect a new set of officials and commissioners to govern the EU until 2019 – was seen by many as opportune. Germany remained resistant.

Cynics also point out that François Hollande hedged a similar offensive on assuming office, which ultimately amounted to little.

But there is a sense in EU circles that there could be more willingness now for change. The probable nomination of former French finance minister Pierre Moscovici to succeed Olli Rehn as EU economic and monetary affairs commissioner next week, despite Berlin's resistance, is seen as something of a coup for the centre-left supporters of greater budget flexibility.

Renzi has also managed to garner the support of fellow-minded politicians from across Europe, with socialist leaders gathering for pre-summit meetings in Paris before the last two EU leaders’ summits in Brussels.

But even if Berlin is not persuaded by other European governments, the German chancellor and finance ministers will be less likely to ignore the comments of the European Central Bank head.

Mario Draghi's suggestion at the annual banking gathering in Jackson Hole late last month that the bank would use "all the available instruments needed" to achieve its target of price stability, is being seen by some as a watershed moment in ECB policy, akin to Draghi's "whatever it takes" comments two years ago.

His decision to go off-script was perceived as a signal of a shift in sentiment. He also called for a "more growth-friendly overall fiscal stance for the euro area", an apparent boost to the Italian-French plea for greater fiscal flexibility and a rebuff to Germany. "ECB President Mario Draghi's speech at Jackson Hole last Friday was a major event and marked a turning point in ECB rhetoric," wrote Philippe Gudin of Barclays.

But how the ECB will use "all available instruments" is, as always, the key question. At issue in particular is the bank's willingness to engage in quantitative easing.

Despite debate over the merit and suitability of a quantitative easing programme for the euro zone economy where banks are the main providers of credit, the ECB has been widely criticised for not following Britain, the US and Japan and engaging in bond-buying. Some analysts believe, however, that a quantitative easing programme will not be initiated until after the results of the European banking stress tests, most likely in December.

Quantitative easing

Instead, the bank will wait and see the impact of its new round of cheap long-term funding for banks which was announced in June and commences this month. As signalled by

Draghi yesterday, it will also proceed with a programme to buy asset-backed securities, having engaged BlackRock to help devise a programme.

Despite criticism over the ECB’s delay compared to other central banks in implementing quantitative easing, it finds itself in a unique position, given that it would have to buy into the debt of multiple euro zone states. Germany is still staunchly resistant to the ECB buying sovereign, particularly peripheral, debt, given that it involves a level of mutuality.

Draghi’s Jackson Hole comments also revisited a well-trodden debate. Where does responsibility for economic governance of the euro zone lie? In the monetary policy of the zone’s central bank, or in the fiscal and structural reforms made by individual governments and countries?

Draghi’s comments suggested there may be a readiness by the ECB to take more responsibility for monetary stimulus, rather than falling back on the constant refrain of fiscal retrenchment. But Draghi – and most certainly Angela Merkel – will be careful to emphasise that any fiscal loosening must be accompanied by structural reform.

Indeed, the strong improvement in the economic situation of bailout countries such as Ireland gives succour to austerity hawks that stringent cuts and entrenchment works.

There are tentative signs that France and Italy may be willing to sign up to this delicate balance of structural reform in exchange for more flexibility. Last week's sacking of a group of left-wing socialists, including economy minister Arnaud Montebourg, showed a willingness by the embattled Hollande to push ahead with structural reforms.

However, a speech by French prime minister Manuel Valls at last weekend's party conference in La Rochelle – to cries of "Vive La Gauche" from the crowd – showed France's tendency to push responsibility back onto Brussels, as the French prime minister pledged to keep the 35-hour working week and called on the EU to adopt pro-growth policies.

Good news for Ireland

Italy similarly can be seen to have been trying to strike a balance between domestic responsibility and blaming Brussels, urging the European Commission to adopt more flexibility with deficit and debt rules, while also attempting to implement domestic political change, such as its plan unveiled last week for judicial reforms.

All this is good news for Ireland, as it prepares to announce a less severe budget than originally expected. Even though it is in a post-programme surveillance programme, Ireland can expect little kickback from the European Commission about its budget choices, when other, larger member states are struggling to meet their targets.

Whether a fundamental change in policy takes root across the bloc remains to be seen. As always, much of the strategy on policy will be decided in Berlin, as much as in Frankfurt or Brussels. But almost six years after the euro zone crisis began, Europe cannot afford a decade of stagnation and further years of youth unemployment.

Europe is running out of options.