Euro spiral: Now is not the time for more cuts

Warnings are coming from the European Central Bank, and deflation looms

Deflation. It is not a word that we are as familiar with as we ought to be, given that our closest economic neighbour, the eurozone, seems set to sink further and further into that unhappy state next year.

This week we had more of what David Cameron called the “red warning lights” illuminating the economic dashboard. Greek capital markets have suffered another slump, with the government there looking increasingly beleaguered, and a senior member of the European Central Bank Council has warned that the eurozone is “massively weakening”. Germany, long the locomotive, is slowing markedly. And that means less money, and less political support, for any future bailouts that may be needed. Annual inflation across the eurozone is a mere 0.3 per cent, Italy is in recession, and France is suffering immobilisme.

Deflation, then, is the danger, and it is just as pernicious and difficult to control as inflation. Like inflation, it tends to feed on itself, with consumers and companies putting off spending and saving decisions because of a lack of confidence and the expectation that next month or next year the price or cost of any purchase will be lower. That then depresses the economy still further, weakening prices in a self-generating spiral. Most dangerous of all, the real-terms value of Europe’s massive debts and deficits starts to climb, while the ability to service those debts weakens.

So when the head of the Austrian Central Bank, Ewald Nowotny, indicates that the danger is so great that the ECB needs to take urgent action he deserves to be listened to. Regarded as a “swing” member of the ECB Council, his apparent conversion to the cause of monetary expansion is telling. The Bundesbank remains adamant that the ECB must not purchase government bonds issued by eurozone member states, but resistance to that policy, as Nowotny’s defection shows, is growing. The ECB Council remains badly split, so much so that the authority of its President, Mario Draghi, is being undermined. Germany, Luxembourg and France are the blocking force, and the German press is full of rumours about Mr Draghi’s detachment from his Bundesbank colleagues.

About the only good thing to emerge from this quiet crisis is that the euro has been pushed down to new lows, helping Europe’s exports compete, and importing a little inflation into the system. Yet the absence of an ECB policy of massive monetary expansion – of the type seen in Britain, America and Japan – means that deflation is inevitable, even if the ECB acted now, given the leads and lags that inevitably occur when policy shifts. More stagnation and political instability beckons.

That, in turn, means an unpromising background for the structural reforms that many European economies so need to implement. Depressed economies lack the funds to pay for adjustments on the scale required, while unstable, fragile governments lack the will to override the inevitable resistance and riots.

Europe’s long-term problem is not so much monetary as industrial and commercial. To restore growth to normal and raise living standards means liberalising labour markets, deregulating product and capital markets, and opening up competition. Those are projects Europe talked a good deal about in the good times. In a deflationary world, they are unlikely to get much attention.

Whoever wins Britain’s general election next year will have to deal with what is happening in the eurozone as well as the domestic economy. The Bank of England seems set to keep up its programme of monetary expansion, and 2015 will not be the best time for more austerity. The cuts, in other words, should be postponed, if we want to avoid Europe’s deflationary nightmare.