The British economy continues to confound the economists. In the darkest days of the downturn, those of the neo-Keynesian school of thought were worried about deflation. Their rightwing opponents in the ‘Austrian’ school feared the opposite outcome – an inflationary surge triggered by quantitative easing.
So far, it looks like both sides were wrong (as they both are on many other counts). The Austrians, however, can console themselves with the thought that of the two dangers, inflation poses the greatest threat to Britain’s recovery.
Elsewhere, it’s a different story. In a post for the AEIdeas blog, Desmond Lachman describes the spectre of deflation now haunting the Eurozone:
“Consumer price inflation data released yesterday by Eurostat can leave little doubt that Europe is in the midst of a strong disinflation process. Over the past year, inflation for the Euro area as a whole has more than halved from 2.6% for the year ended September 2012 to 1.1% for the year ended September 2013.This is considerably below the ECB’s inflation target of close to but below 2%. At the same time, inflation in the European economic periphery has declined to levels that place the periphery on the cusp of outright deflation.”
Deflation is bad news in any circumstances – but for an economy buckling under the strain of debt it could be ruinous:
“A particularly troublesome aspect of the European disinflation process is that it limits the ability of countries like Ireland, Italy, and Portugal to reduce their public debt burdens. These counties all have public debt burdens of around 125% of GDP. In the context of their ongoing budget austerity policies and their domestic credit crunches, they are also experiencing very little real economic growth. Should these countries actually experience price deflation, it is difficult to see how they might stabilize their already very high public debt to GDP ratios.”
Of course, there are many countries that find themselves deep in the red – ourselves included. However, Britain has the option of suppressing interest rates to reduce the cost of servicing our debts while allowing inflation to erode their capital value.
No such luck for the likes of Spain and Italy:
“…a factor highly complicating the [European Central Bank]’s policy options is… that it has only one monetary policy to fit all 17 countries in the Euro. With the European periphery now on the cusp of deflation and with Germany still experiencing inflation at the rate of 1.6%, it is not clear how much the ECB can do to prevent the European periphery from drifting into outright deflation.”
The northern members of the Eurozone could choose to tolerate a higher-than-necessary inflation rate to prevent deflation in their southern neighbours, but that would go down very badly at home. German voters have already endured a decade of stagnant wage levels – so a self-inflicted rise in the cost of living would be intolerable.
Therefore, the only way forward for the Eurozone is further down the path of banking and fiscal union. Yet while this will help to keep the peripheral member states solvent, it will bind them ever more tightly into exchange rates, interest rates and spending policies that reflect German priorities, not their own.
Of course, Spain and Italy have voters too. And should deflation strike, the only way forward for the Eurozone may be abandoned for the only way out.