The high cost of Europe’s race to the bottom

Hamstrung by the single currency, eurozone countries are going through the slow and painful process of internal devaluation.

As you might expect, the European Central Bank Monthly Bulletin makes for some dire reading. Momentum has slowed throughout the eurozone in recent months and is set to persist for a number of years.

According to the ECB, “the risks surrounding the economic outlook for the euro area continue to be on the downside”. They are particularly concerned about the eurozone’s loss of momentum and the heightened geopolitical risks within the region. That combination “could dampen confidence and, in particular, private investment”.

The ECB is concerned that there has been insufficient progress on structural reforms among countries in the eurozone. In the absence of internal currency manipulation, most eurozone countries have been forced to achieve an internal devaluation. That’s the process through which one country improves its competitiveness via a prolonged period of low inflation compared with other countries in the eurozone.

It’s a slow and painful process, made all the more difficult by the eurozone’s inability to create sufficient inflation. As euro-wide inflation has eased, countries such as Spain have been forced into deflationary territory to improve their competitiveness. That will work in the long-term but at a considerable cost to their productive capacity and citizens.

That isn’t to say that the foreign exchange market cannot help a bit, but it remains an inadequate tool to improve competiveness within the region. In countries such as the United Kingdom and Australia, the exchange rate will do most of the heavily lifting to fix competitiveness. That’s not the case in the eurozone, where the euro is never at a level that is suitable for everyone and often not suitable to most.

For example, the euro is around multi-year lows against the US dollar but remains too weak for the likes of Germany and much too strong for the likes of Spain, Greece and Portugal.

The outlook for inflation remains fairly mixed but the ECB is optimistic that consumer prices will begin to rise at a faster pace over the year ahead. More recently, prices have been weighed down by softer oil and food prices -- a similar theme across most developed countries -- and the effect of this will gradually diminish in the headline data.

Deflation remains a concern for the eurozone -- and will continue to do so while the unemployment rate remains elevated and growth hard to come by -- but the core measure of inflation is at 0.7 per cent and indicates that there is still some way to go before deflation becomes a reality.

Not helping matters is the fact that financial markets continue to be hampered by insufficient aggregate demand. Willingness to lend is already low so that the lack of demand creates a toxic mix.

The value of loans to non-financial corporations fell by 1.8 per cent over the year to September, although the pace of decline has eased modestly in recent months. By comparison, credit to households has increased by 0.6 per cent over the same period.

Unlike many developed countries which suffered during the global financial crisis, there has been no housing boom built on easy money in the past few years. While the Bank of England had to intervene to slow the London housing market, the same cannot be said for central banks across Europe, highlighting the very different state of their business cycle.

Finally, the ECB noted that “countries with remaining fiscal imbalances should not unravel the progress already made and should proceed in line with the rules of the Stability and Growth Pact”. In recent months, both France and Italy have shown signs of wavering, with austerity measures proving devastating for households and businesses alike and, so far, having little effect on measures of gross government debt.

The Stability and Growth Pact -- which admittedly is already largely ignored -- will only come under increasing pressure in the months and years ahead. This European crisis has a long-way to run and I don’t expect the ECB to raise interest rates until next decade. To facilitate a long and persistent recovery, the ECB needs greater support and policy coordination from those countries that can afford to stimulate their economies. If that runs contrary to the Stability and Growth Pact, then so be it.

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