Paralysed ECB leaves Europe at the mercy of deflation shock from China
China will seek to pass its deflationary parcel to Europe, the one region that lacks a proper central bank and the governing coherence to protect its own interests
By Ambrose Evans-Pritchard
9:06PM GMT 12 Mar 2014
By this measure, inflation since June has been running at a rate of -1pc in France, -2pc in Holland, Belgium and Slovenia, -4pc in Italy, Spain and Portugal, -6pc in Greece and -10pc in Cyprus. Sweden and Switzerland are also in deflation.
Germany rolled over in July. The UK still clings to a little inflation - now a precious commodity - but it too turned negative in September.
This is a nightmare for the debt-stricken states of southern Europe, still trapped in a slump with mass unemployment regardless of whether they manage to eke out the odd quarter of miserable growth. With Germany at zero inflation, they have to go into even deeper deflation to claw back lost competitiveness within EMU under "internal devaluations".
This, in turn, plays havoc with debt dynamics through the denominator effect. Their debt loads are rising on a base of flat or contracting nominal GDP. It is a key reason why Italy's public debt has risen from 119pc to 133pc of GDP since 2010 despite achieving a primary budget surplus, or why Portugal's debt jumped from 94pc to 129pc (IMF data).
These countries have an impossible task, damned if they do and damned if they don't. Mr Blanchard said their gains in competitiveness risk being overwhelmed by a rise in the "real value" of their debt. "The danger is that the second effect dominates the first, leading to lower output and further deflation."
There is, of course, no magic line when inflation falls below zero. A recent IMF study said the effects become lethal for economies with high public/private debt loads - mostly over 300pc of GDP in Club Med - even at "lowflation" rates.
The European Central Bank is betting that this is downward lurch in prices is a temporary blip due to lower energy costs, insisting that inflation expectations remain "firmly anchored". The collapse of iron ore and copper prices over recent days - on China jitters - should puncture these illusions.
The ECB's expectations doctrine is in any case a Maginot Line. "Long-term inflation expectations on the eve of three deflationary episodes in Japan were also reassuringly positive," said the IMF. Indeed, they were a lagging indicator and therefore useless.
"One needs to act forcefully before deflation sets in," said the Fund, adding that the Bank of Japan was too slow to cut rates and boost the money base. "In the event, it had to resort to ever-increasing stimulus once deflation set in. Two decades on, that effort is still ongoing."
BoJ governor Yasuo Matsushita said as late as January 1998 that there was "no reason to expect that overall prices will drop sharply and exert deflationary pressure on the entire economy". As a result of this lordly certitude, Japan suffered shattering effects when the East Asia crisis entered its second and more deadly phase that summer.
The ECB's Mario Draghi risks going down in history as Europe's Mr Matsushita, as he continues to insist that EMU inflation today is merely where it was in 2009 (in the post-Lehman mayhem) and therefore benign, and that Euroland is not remotely like Japan. "The ECB has taken decisive action at a very early stage of this crisis,” he said.
The proof is in the monetary pudding, and this shows that EMU is already in worse shape than Japan in early 1998 by a large margin. Private lending is contracting at 2.3pc, the M3 money supply has ground to a halt and EMU-wide unemployment is stuck at a near-record 12pc.
The ECB is by definition ferociously tight. Marcel Fratzscher, head of the German Institute for Economic Research (DIW) in Berlin, is right to berate the bank for betraying its primary duty, demanding €60bn of bond purchases each month before it is too late. "It is high time for the ECB to act. Otherwise Europe risks falling into a dangerous downward spiral," he said.
Euro Intelligence said failure to act would be "an existential disaster for the eurozone" and a "shocking derogation" of the ECB's mandate.
Mr Draghi has bent over backwards to assuage the hard-money monks at the Bundesbank - much to the fury of one ex-ECB governor who told me he had become the "captive" of Right-wing German elites - judging that it would be too risky for the Latin Bloc and their allies to mobilize their majority voting power and force through a reflation policy.
His task has become even more complicated since the German constitutional court ruled last month in thunderous language that the ECB’s bond rescue plan for Italy and Spain (OMT) "exceeds the ECB’s monetary policy mandate, infringes the powers of the Member States, and violates the prohibition of monetary financing of the budget”. It also said the OMT is probably "Ultra Vires", meaning that the German Bundesbank may not take part.
The ruling is not final - and does not prohibit ECB bond purchases as such - but it raises the bar for quantitative easing to a punishingly high level. While the Fed and the Bank of England were able to act instantly once it became clear that QE on a huge scale was imperative, the ECB is paralysed by politics, ideology and judges.
There have been dovish mutterings from ECB members over recent days but any action is likely to be confined (for now) to token gestures such as a negative deposit rate or easier collateral rules for banks, not the €1 trillion blast of QE that is so obviously needed immediately. The rise in the euro to €1.39 against the dollar tells us that markets expect nothing of substance.
Europe is left at the mercy of world events. The Fed is pressing ahead with $10bn of tapering each meeting, slowly forcing up the global price of credit and tightening the vice further for emerging markets. The bank has ignored the pleas for mercy from the developing world - still addicted to dollar liquidity - just as it did in the months before the Asian crisis in 1998. The OECD warned this week that the real impact of Fed tapering has "only just begun" and the effects threaten to ricochet back into Europe through trade and banking stress in emerging markets.
China is tightening as well in what amounts to a G2 monetary squeeze. It has been so successful that shadow banking virtually froze in February, prompting the central bank to step back in consternation at its own handiwork.
Some have a touching faith that the Communist Party knows what it is doing, even though it is the same body responsible for just having blown the most spectacular credit bubble of modern times, more than a match for the pre-Lehman booms in Greece, Spain or Ireland in character and much greater in scale. I prefer the Chinese metaphor of feeling the stones beneath the water, their way of saying trial and error.
China will not collapse because the banking system is an arm of the state, but it will have to cope with the colossal malinvestments left from a hubristic five-year blow-off. Deflation is already stalking the country. Factory gate inflation has dropped to -2pc.
We can be sure that China will seek to pass this deflationary parcel to somebody else, just as the Japanese have already done with their epic devaluation under Abenomics. The package will land in Europe, the one region that lacks a proper central bank and the governing coherence to protect its own interests. The implications for the depression-wracked societies of the Mediterranean are nothing less than calamitous.