Just when it seems Europe's bedraggled underachievers have finally embarked on a long climb out of their deep economic hole, something nasty comes along to pull them back down. While officials have trumpeted the recovery in the recession-wracked 17-country euro zone, which has posted modest growth since the second quarter, unemployment remains high. And now, the single-currency club faces a more dangerous health risk stemming from fiscal consolidation, a surprisingly strong euro, excess capacity and tight credit conditions: economy-crippling deflation.
The harmonized index of consumer prices [HICP], a closely watched Eurostat gauge that removes the effects of price increases stemming from tax changes, shows that inflation across the region fell below 1 per cent in September, the lowest level since the financial collapse of 2008 and well under the 2 per cent considered ideal by most central banks. The European Central Bank's own price stability target is slightly lower at just under 2 per cent.
Prices have been falling for several months in France, Italy, Spain and the usual peripheral suspects. Sweden's harmonized inflation rate rose 0.48 per cent annually in September. Denmark was at 0.17 per cent. Economist Lars Svennson, a longtime colleague of fellow Princeton professor Ben Bernanke who became deputy governor of the Swedish Riksbank, quit his post there last spring over the board's failure to respond to the economic malaise and the growing deflation threat with aggressive interest rate cuts.
Even in Germany, which has managed to step around the major economic potholes, HICP inflation is expected to be no higher than 1.6 per cent, year over year, for October. So if the inflation hawks at the Bundesbank continue to oppose an aggressive monetary counter-attack to keep the region from sliding into the deadly trap of deflation, they won't have much of an argument to mount. The meagre growth in Europe shows little risk of setting inflation expectations alight, never mind sparking a hiring spree among the continent's 26.6 million unemployed.
Japan, which has been stuck in a deflationary spiral for much of the past decade, has embarked on its most ambitious effort yet to kickstart inflation with a combination of massive quantitative easing and public spending. If the ECB fails to do some aggressive easing of its own and various governments don't loosen the fiscal screws, Europe's slide into outright deflation could be even more painful, because the already high costs of servicing heavy debts would rise dramatically. The result would almost certainly be a run of defaults in the weakest euro zone members, regardless of what the Brussels spinmasters call them.
One analyst estimates that for every decline in inflation of a percentage point, Italy will have to boost its primary budget surplus by an additional 1.3 per cent of GDP (above the current target of 5 per cent) merely to tread water on the debt front.
"Despite Europe's continual moving of the goalposts to give countries more breathing room, the economic paradigm … is still the same: austerity," Edward Harrison, Washington-based founder of the Credit Writedowns blog, commented in a note last week. "This will dampen growth in Europe for the foreseeable future and increase government debt to GDP ratios, making debt deflation and crisis a background threat which will eventually result in sovereign restructurings regardless of recovery."
In other words, austerity kills.