EMU deflation is the final betrayal of southern Europe

The victim states of southern Europe have retrenched heroically, yet deflation effects are overwhelming them

A one euro coin is melted with a welding torch in this photo illustration
The optimal moment for the ECB to launch quantitative easing has passed Credit: Photo: Reuters

The eurozone has let it happen. Europe's authorities have so mismanaged monetary and fiscal strategy that the whole currency bloc has tipped into deflation.

The drop in the eurozone's headline price index to -0.2pc in December scarcely captures the significance of what is happening. Deflationary forces have been gaining a grip on all the crisis states of the South for 18 months.

A chorus of economists began warning two years ago that the region was sailing close to the wind by letting inflation drift ever lower, leaving itself one shock away from a loss of policy traction. That shock is now hitting in successive waves: the Russia crisis; China's over-investment glut; and now the collapse of oil prices.

Textbook theory suggests that a halving of energy costs should be cause for celebration, a tax cut for consumers. It is very different calculus when inflation is already zero, bond yields are plummeting to 14th century lows across the world, and market psychology is becoming "unhinged" - to use central banking vernacular.

“Normally, any central bank would prefer to look through a positive supply shock," said Peter Praet, the European Central Bank's chief economist. "But we may not have that luxury at present. Shocks can change: in certain circumstances supply shocks can morph into demand shocks via second-round effects."

Mr Praet said families and firms are already adapting pre-emptively to the new order, describing what amounts to a classic deflation trap. "There is a risk of a real economic vicious cycle: less investment, which in turn reduces potential growth, the future becomes even grimmer and investment is reduced even further," he told Börsen-Zeitung.

Mr Praet warned that an "underemployment equilibrium" is setting in, invoking the term used by Keynes in the 1930s. He exhorted "all the authorities", including governments, to step up to their responsibilities and take "urgent action". This is a man who knows that monetary union is in deep crisis.

His boss, Mario Draghi, has been bending every sinew for a long time to head off this awful moment. He went to Berlin as far back as November 2013 to plead for understanding from Germany's economic elites, warning even then that radical measures were needed to secure a “safety margin against deflationary risks”. He feared that the downward slide was pushing EMU crisis countries into a deeper rut as they tried to claw back competitiveness. "Real debt burdens rise,” he said.

Mr Draghi did not invoke Irving Fisher's classic text published in 1933 - Debt-Deflation Theory of Great Depressions - but his message was the same. Falling prices are not benign in highly-leveraged economies.

There comes a point when the sailing ship does not right itself by the normal swing of the cycle. It tips too far and capsizes. Try to right it then. The Japanese are still trying 15 years later.

There have been incessant promises of ECB stimulus since that speech in Berlin but little has been done, despite Mr Draghi's valiant efforts. The ECB's balance sheet has contracted further due to "passive tightening", falling by €143bn to €2.15 trillion.

The optimal moment for quantitative easing has passed. It is late in the day, even if the ECB council plucks up the courage this month to force through full-blown QE against guerrilla resistance from the Bundesbank. Yields on 10-year German Bunds have already dropped to a historic low of 0.46pc. Finland is down to 0.54pc, Holland to 0.57pc and France to 0.73. Even Spain has fallen to 1.63pc.

Little can be done by compressing yields yet further, and the ECB is prohibited by treaty law from carrying out more radical action that injects money directly into the veins of the economy. Most likely it will be another fudge, an overly complex formula that avoids any real sharing of risk. Hedge funds may pocket a profit. But it will not create many jobs in Naples.

Without such jobs, Italy's political system is going to blow up soon. Its unemployment rate has just reached a modern-era high of 13.4pc, with youth unemployment hitting a record 43.9pc. The Mezzogiorno is sliding from depression towards social collapse. The Bourbons made a better fist of it.

By cruel contrast, Germany generated 27,000 fresh jobs in December. Unemployment has fallen to a 23-year low of 5pc. Things have never been so good since reunification. There could hardly be clearer evidence that monetary union is unworkable.

The victim states of southern Europe have retrenched heroically, yet deflation effects are overwhelming them. Their debt trajectories are still spiralling up due to the mechanical effect of sticky interest costs on a base of catatonic nominal GDP.

Spain's inflation rate has fallen to -1.1pc, a curse oddly welcomed by the pre-modern Partido Popular as proof that the country's "internal devaluation" within EMU is gaining traction. It certainly is, but the final outcome may not be what they think.

For Italy it is slow torture. Contractionary policies have already pushed the debt ratio from 116pc to 133pc of GDP in three years. Each one percentage point fall in Italian inflation forces the country to increase the primary surplus by 1.4pc of GDP to meet EMU rules, according to the Bruegel think-tank in Brussels. Yet to act on this imperative is to thrust the economy further into a self-reinforcing downward slide.

Optimists think the eurozone has touched bottom. Simon Ward, from Henderson Global Investors, says the forward-looking money supply figures are flashing recovery. His key gauge of narrow M1 - six-month annualised growth - surged to 9.9pc in November. Let us hope that this is the harbinger of reflation, though one wonders what M1 money data still tell us in a mad world of zero rates and zero inflation, where there is no opportunity cost for leaving money idle in M1 cash accounts.

The counter view is that something odd is happening in the global economy. China's factory gate deflation has dropped to -2.7pc, a sign of massive spare capacity. The country's fixed investment reached $7.24 trillion in the first 11 months of 2014, more than in Europe and North America combined. The scale is vast: the deflationary effects are galactic.

Behind it is an excess of capital as the world's savings rate hits a record 26pc of GDP, starving the real economy of demand. One culprit is the $12 trillion accumulation of foreign reserves by central banks. Another is the deformed structure of globalisation, which favours the owners of capital and concentrates of wealth. Add the demographic tipping point across the Pacific Rim and central Europe, and you have a portrait of worldwide "secular stagnation".

The eurozone is least able to respond because it is a dysfunctional construct. There is little point blaming those now in office. The Telegraph has argued since Maastricht that a currency union of disparate cultures with no EMU treasury or political authority to guide it would end in paralysis, with feedback loops entrenching divisions over time.

Mr Draghi issued his own cri de coeur in Helsinki six weeks ago, laying out the "minimum requirements for monetary union". His prescription amounts to an EU superstate, with economic sovereignty to be "exercised jointly".

His plea is Utopian. There is no popular groundswell anywhere for such a vaulting leap forward, and it would imply a technocrat dictatorship beyond democratic control if ever attempted. The northern creditor states have in any case spent the past four years methodically preventing any durable pooling of risk or any step towards fiscal union.

In airing such thoughts, Mr Draghi is really telling us that he no longer thinks EMU can work. Nobody can fault him for lack of effort.