Deflation risks, QE and ‘Grexit’ revealing the cracks in the eurozone edifice
These recent events are sending out one and the same message: the eurozone crisis is not over, and big segments of the single European currency union have still not been properly constructed.
Inflation is very subdued throughout the eurozone. But it is not so low just because oil prices have been nosediving. Depressed aggregate demand acts as a fertile breeding ground for a deflationary spiral to take root. Confronted by this risk, the ECB has at long last provided its unconventional response to meet this challenge. However, unless foreign demand rebounds noticeably or stimulus is forthcoming via fiscal policies, monetary policy alone is highly unlikely to be powerful enough to drag the eurozone economy out of the quagmire. At a time when the Greek economy is finally in a position to harvest the first fruits of the huge efforts and sacrifices made, these may evaporate into thin air as a result of overweening demands being made by the new government. These three turns of event tell us the eurozone is still built on rather shifting sands. The authorities will, therefore, be continually required to react to underpin and buttress the still shaky eurozone edifice.
Dangerous slide in the direction of a deflationary spiral
Eurozone inflation sank to -0.6% y-o-y in January, matching its all-time low recorded in July 2009 when the economy was being buffeted in the after-shocks from the Lehman Brothers collapse. Moreover, this noticeably negative rate of inflation is not only a problem in the troubled countries. Most countries (10 out of 19) are running a negative rate of inflation (1), including several core eurozone states (Germany, Belgium, Luxembourg), and even the fastest rate in the eurozone (Austria) is pitched below 1%. Low inflation is widespread and not just the fault of a few countries languishing in recession.
Nor is the tumbling oil price solely to blame. Just before the price of oil began to plummet in June 2014, eurozone inflation was only running at 0.5%, and even that rate was an anomaly. That could be put down to lacklustre aggregate demand, attributable to the crisis impact and austerity policies, aggravated by very uninspiring potential growth (2). Falling energy prices, generally speaking, are good news for importing countries as the ensuing increased purchasing power nurtures hopes of an upturn in consumer spending. However, when the economic outlook is bleak, the labour market is flaccid and the prices of goods and services are sliding, economic agents may well curb their propensity to spend or invest. Any gains made from cheaper oil and energy bills may well be squirrelled away as savings rather than spent on consumption. If economic players do change their behaviour in this way, the lessons learned from past experience may no longer be as relevant or, at least, may lead to over-optimism.
The pressing need for QE
When economic agents suddenly find themselves burdened with debt as a result of some shock (sub-prime crisis, Lehman Brothers collapse, Greek sovereign debt crisis, property crashes in Spain and Ireland, eurozone systemic crisis), they all decide to deleverage at one and the same time. That triggers a slump in aggregate demand and results in a deep recession. What can the policymakers do to turn this around? In principle, there are two different schools of thought. The first advocates giving market forces free rein to work – insolvent businesses would be allowed to go to the wall on the grounds that trying to keep them afloat would be an inefficient allocation of resources. The risk inherent in this approach is a critical systemic collapse. If a bank goes bankrupt, it weakens other banks and potentially triggers a domino effect. The second line of thinking considers that the cost of a systemic crisis for society is greater than the cost of rescuing and bailing out a few liquidity-strapped banks. In the recent crisis, US and UK policymakers unmistakably adopted this latter approach. Much the same could be said for the eurozone, except that putting it into practice has been sorely complicated by the fragmentary nature of decision-making and reluctance about acceding to the fiscal transfers this particular approach demands.
Once benchmark interest rates are at zero and shrinking aggregate demand feeds through into disinflation, interest rates in real terms start to rise. That involves an undesirable tightening of monetary conditions, running the risk of further curbing consumer spending and investment. To cope with this dilemma, the monetary authorities have to take action, by printing money to purchase assets, in order to prevent a deflationary spiral from taking a grip. Such transactions, referred to as quantitative easing, are intended to cause inflationary expectations to harden again and, through a feed-through effect, halt the rise in real interest rates. Buying assets also serves to bolster the balance sheets of economic agents.
QE is, therefore, essential to prevent an economy from being sucked down into a deflationary spiral which would be ruination for those economic players saddled with debt. However, QE cannot alone revitalise demand as the overindebted agents continue to rein in their spending and investment in order to lower their debts. Pulling out of the crisis can only come from private sector domestic players, so two more factors are usually required to rescue the economy from the doldrums: either a revival in foreign demand or budget stimulus from the public sector.
Mist of half-truths hanging over Greece
A number of presumptions about the state of Greece’s economy have been consistently touted as axiomatic truths since the general election on 25 January. Far from being corroborated evidence, these points need to be delved into in closer detail.
It is commonly asserted that the Greek government will never be able to pay back its debt. This affirmation calls for some clarification. A government or state is not the same as either a household or a business. It does not have an overriding urge to reduce its borrowings to zero. Indeed, modern-day economies, especially when it comes to monetary policy, would not work without public debt. So, the challenge facing a government is not to pay off its debt, but simply to be able to roll over or renew its borrowings regularly. This means when a bond comes to term, the government must be able to issue a new bond on acceptable terms and conditions (similar coupon rate) so it can reimburse those investors who had owned the maturing bond. Herein lies the nub of the problem for Greece. In view of the clouds of uncertainty over Greece’s future seat around the eurozone table, investors are insisting on being rewarded with sizeable risk premiums (from 16% on a 3-year bond to 9% on a 10-year maturity). Faced with such demands, Greece cannot realistically secure financing on capital markets. As things stand, 75% of Greece’s public debt is in the hands of public agencies (European Financial Stability Facility (3) and the ECB) which can offer Greece advantageous terms for its borrowings. The debt has been rescheduled on to much longer-dated maturities. Coupons have been steeply reduced. Gains earned from these Greek bonds owned by public bodies are, moreover, handed over to Greece. In 2014, Greece’s bill for servicing its debt worked out at 4.3% of GDP, less than for Portugal (5.0%) and Italy (4.7%), and only a fraction higher than for Ireland (4.1%). On the face of it, therefore, servicing its debt looks quite sustainable, especially considering Greece has returned to the path of economic growth in the last three quarters (averaging +0.6% q-o-q), booked a current account surplus for 18 months now and recorded the biggest primary surplus (4) throughout the eurozone at 2.5% of GDP, beating Germany’s 2.1% or Italy’s 1.7%.
It would be wrong to paint too rosy a picture though. The people of Greece have made gargantuan efforts, and they are fed up after five long years of harsh austerity. Nevertheless, it would be a calamitous mistake if the benefits from all the sacrifices made were to be frittered away in a few populist measures at a time when the light has finally been glimpsed at the end of the tunnel. Genuine opportunities are knocking on the door for the Greek government as there has even been a discernible shift in mood in Brussels. All-out austerity is no longer the order of the day. The European Commission recently noticeably softened its interpretation of rules on budgetary discipline. Budget belts throughout eurozone member states are being loosened a notch or two. A more benign breeze in favour of possible concessions seems to be blowing: debt rescheduling, further coupon reductions and a toning-down of targets for the primary surplus would appear acceptable demands for the Greeks to make in the circumstances. However, if Greece’s new political leaders were to adopt too aggressive or intransigent a stance, this might well irritate creditor member states and sour their more benevolent humour.
Eurozone set to be subjected to regular endurance and resilience tests
Widespread low inflation in the eurozone is a timely reminder that the risks of a deflationary spiral are very real indeed. Admittedly, the ECB has finally pushed through initiatives up to the measure of the challenge, but past experience in Japan reveals that, without support from external demand or fiscal stimuli, monetary policy alone is most unlikely to be strong enough to pull the eurozone economy out of the quagmire. Lastly, the resurgence of the whole Greece question is yet another warning-shot about the lack of appropriate institutional response to the structural asymmetries plaguing the eurozone.
It has already become an over-used cliché that, without its fiscal cornerstone, the single European union is a wobbly construction. In the near term, we are very unlikely to see either popular or political will to cement any sort of fiscal union to slot neatly alongside monetary union. Some progress has undoubtedly been made since the crisis flared up (European Stability Mechanism; uniform stress testing; Single Supervisory Mechanism), but, as things stand, the eurozone is still rather precariously balanced, possessing the characteristics more of a potentially dissolvable regime of fixed exchange rates than of a permanent monetary union. In such circumstances, the economy will continue being hampered by deleveraging and the blatant lack of any underpinning from budget policies. The authorities will, therefore, be continually required to react to underpin and buttress the eurozone edifice.
1. We have deliberately avoided using the term ‘deflation’. The eurozone has, fortunately, not yet come to that sorry pass. Deflation is an extreme state when the prices of goods and services are falling across the board, resulting in a parallel slump in asset prices.
2. For more on this, see the Topic of the Month article – Growth deficit in the crisis aftermath – in the October 2014 issue of Perspectives.
3. The European Financial Stability Facility (EFSF) was set up in May 2010 in response to the emergence of the crisis in Greece.
4. Economic criterion having a decisive bearing on the sustainability of debt.