ECB sees downward price trend as good sign despite risks of deflation

Spain views inflation drop as an indicator that adjustment is on the right track

Alejandro Bolaños
Jobseekers wait in line outside a Madrid unemployment office.
Jobseekers wait in line outside a Madrid unemployment office.Paul White (AP)

Can something be good and bad at the same time? Yes, according to the European Central Bank's (ECB) reading of the downward trend in prices.

For the ECB the fact that prices are falling in countries undergoing severe adjustments such as Spain and Greece is good news. But the fact that inflation in the euro zone as a whole is deviating from the ECB's medium-term target of close to, but below, two percent (it was 0.7 percent in October), when economic activity remains stagnant, is a bad sign. And what the ECB's unexpected cut in its key intervention rate to 0.25 percent at the start of this month points to is the fear of the worst of ills in an economic crisis: deflation.

The Great Depression in the United States in the 1930s bears bitter witness to the destruction that can be wreaked by a persistent and generalized fall in prices. A more recent experience of its effects was the stranglehold inflicted on the Japanese economy in the 1990s, from which it has yet to fully recover. What happened to the once-dynamic Japanese economy has led experts of late to speak of the "Japanization" of Europe.

Even more recently, in 2009, during the "Great Recession," which came in the wake of the global financial crisis unleashed by the demise of Lehman Brothers in 2008, inflation turned negative in the majority of western countries. That development as a result of the global economy's collapse is even more salient in that 2008 was marked by a run-up in raw material prices. José Carlos Díez, who teaches economics at the ICADE business school, believes the striking difference between the Great Depression and the Great Recession "was the response." The G20 governments launched a coordinated and unprecedented fiscal stimulus drive, while Western central banks injected massive amounts of liquidity into the system and rapidly lowered interest rates.

A slowdown in the Chinese economy could be the death blow for Europe

The United States didn't stop there. It embarked on a herculean bail-out of the financial sector, while the US Federal Reserve cut interest rates to zero and intervened directly in the economy through quantitative easing, buying up public debt and fixed-interest paper issued by the private sector to prop up the value of assets.

"It doesn't explain everything, but the US jobless rate is 7.3 percent, while in the euro zone it is at 12.3 percent and rising," says David Cano of the Spanish think-tank Analistas Financieros Internacionales (AFI).

The euro zone went down a different road when the crisis and fiscal stimulus packages put pressure on the finances of some member countries of the single-currency bloc such as Spain. Budget cuts, structural reforms and salary cuts in order to restore competitiveness as a means of returning to growth was the remedy prescribed for the countries in the most difficult situation. The restructuring of the banking sector came later and at a much higher price. The ECB was always behind the Federal Reserve when it came to taking action.

Students of the Japanese experience insist that a combination of fiscal austerity and monetary policy orthodoxy has brought Europe to the ante-chamber of deflation. "When the private sector needs to reduce debt after a bubble, the worst thing you can do is to insist on lowering the public deficit to three percent of GDP," wrote Richard Koo, an analyst with the Japanese investment bank Nomura, in a report earlier this year. In a meeting this month with analysts, Albert Edwards, a strategist with Société Générale, said Europe is moving toward a deflationary spiral and a slowdown in the Chinese economy could be the death blow.

The ECB was always behind the US Federal Reserve in taking action

When ECB President Mario Draghi earlier this month explained the rationale behind the rate cut he denied there was a risk of deflation, but forecast a prolonged period of low inflation that could put the euro-zone supervisor's two-percent medium-term target at risk in the absence of intervention. Draghi said the trend toward lower inflation was in part welcome as a process of adjustment between the relative prices of different countries. By this he meant a process of lower wages in countries such as Spain with high unemployment and tight credit aimed at improving competitiveness and reactivating growth.

However, Draghi also highlighted that this process could be frustrated if inflation in the euro zone as a whole failed to adhere to the medium-term target of two percent. In clear reference to Germany, Draghi also indicated that countries with huge savings should channel them toward stimulating domestic demand as a means of pushing up inflation.

Spanish inflation turned negative in October, albeit barely at minus 0.1 percent. However, domestic think-tanks such as the Flores de Lemus Institute and Funcas believe that this is a temporary phenomenon and predict moderate inflation of over one percent in 2014. The Economy Ministry concurs with this and agrees with Draghi that "the moderation in prices has a positive impact on the spending power of pensions and salaries, and improves competitiveness, exports and the recovery."

Others are not quite so sure. "Deflationary pressures in Spain are very real," the research department of JPMorgan said in a report this month. The IMF vulnerability to deflation index also indicates Spain is at high risk. "The lack of credit has a much more deflationary impact on Spain than the fiscal adjustments," says ICADE's Díez, who is calling for a pan-European stimulus package that has "real impact." He described the EU initiative to set aside six billion euros to address high youth unemployment as "a joke."

It is evident that the euro zone has started to change tack of late. There is no longer the same rabid insistence on the merits of austerity, while the ECB - four years after the Fed - moved to bring interest rates near zero and has now shown itself open to using extraordinary measures.

The ECB is also due to examine the state of Europe's banks next year in what it is hoped will lead to a definitive restructuring of the sector. However, the question remains, as AFI's David Cano puts it, "if this will come in time" to ward off deflation.

Lower wages yet to create more jobs


Inflation turned negative again last month for the first time since the "Great Recession," but labor costs have been falling since the spring of last year. In December of 2012 wage costs per worker fell 3.6 percent when inflation was 3 percent.

The country's main labor unions CCOO and UGT and the business community agreed to a wage-moderation pact at the start of last year as a means of at least trying to preserve jobs. But since the government introduced its labor reform in February 2012, making it cheaper and easier to sack workers, unemployment has in fact increased by half a million people.

The theory is that with lower wages and steady prices, companies become more competitive, sell more, stimulate activity, and end up hiring more people. However, as Javier Andrés of the University of Valencia says: "Internal devaluation has still not had the impact we wanted to see." But he insists that in the absence of the ability to devalue their currency, the only alternative for euro-zone member countries such as Spain to restore competitiveness is to lower wages.

Ángel Laborda, an analyst with the think-tank Funcas, is more optimistic, predicting that the economy will start to create jobs in the first half of next year.

However, Carlos García Serrano of the University of Alcalá is skeptical about the theory of low wages. "Spain was already competitive in 2008 and 2009 because, along with Germany, it was the only [country in the euro zone] that increased its export market share. The argument that lower wage costs should translate into more jobs doesn't have to be the case because there are also financial issues."

The majority of economists believe the reason why the number of jobs has fallen rather than risen or stayed the same is because companies have been reluctant to trim their margins, and therefore, the benefits of lower wages have not been passed through to prices.

Andrés, of the University of Valencia, said price cuts always fall behind drops in wages because companies act in a contra-cyclical way. They tend to lower prices during boom periods because this is compensated by higher sales and when sales fall in downturns they tend to increase their margins to offset the loss of revenues, particularly companies that need to service heavy debts.

Recomendaciones EL PAÍS
Recomendaciones EL PAÍS