As Europe’s economy recovers from its crisis, afflicted countries such as Spain and Italy are trying to pare their debts while also becoming more internationally competitive.
The trouble is, it’s hard to do both at once. And the euro zone’s weak inflation is making it even harder.
So, even as the world’s economic elite welcomed a strengthening global recovery at last week’s gabfest in Davos, Switzerland, the euro zone’s wounds are likely to heal only very slowly–and might even reopen.
Until the crisis, the euro zone’s “periphery” countries, mostly in Southern Europe, had higher inflation than the region’s “core” economies around Germany. The periphery countries’ products became too expensive, often leading to unsustainably large trade deficits paid for by borrowing from abroad.
Without national currencies to devalue, periphery countries need to push down prices and wages relative to core Europe to regain competitiveness. For years to come, inflation will have to be lower than the European average.
But cutting debt burdens is easier for households, companies and nations if their nominal incomes, which rise with inflation and growth, are expanding. Solvency–and resilience in future financial crises–depends on reducing debts as a proportion of gross domestic product. That means the lower that inflation in Europe falls, the greater the tension between repairing solvency and raising competitiveness.
Bruegel, a nonpartisan economics think tank in Brussels, calculates that Spain and Italy can painstakingly bend their rising public-debt-to-GDP ratios downward in coming years if their economies grow, they run very tight budgets, and euro-zone inflation is close to 2%, the European Central Bank’s target.
But if the bloc’s overall inflation is only 1%, then the need to become cheaper relative to Germany would push inflation in Italy and Spain toward zero. In that case, lower nominal GDP makes debts look uglier. Spain’s debt could rise to 120% of GDP, while Italy’s could surpass 140%, Bruegel projects.
The annual pace of euro-zone inflation has now sunk below 1%. Spanish inflation is nearly nil, and Italy’s is dwindling. Even Germany, which needs inflation well above 2% in Bruegel’s optimistic scenario, is below the target. The bleaker scenario is in danger of coming true.
“My fear is that it may prove to be very difficult for these countries to achieve the dual goals of public-debt sustainability and a durable improvement in competitiveness,” says Zsolt Darvas, senior fellow at Bruegel.
If prices fall outright, Greece shows what can happen: Deflation is playing havoc with the country’s solvency, pushing its debt-to-GDP ratio ever higher despite draconian budget austerity.
While Italy and Spain aren’t grappling with deflation, even very low inflation can create a bad feedback loop. It entails more austerity to stabilize debts, slowing the recovery. And if nominal incomes disappoint, households and businesses have to spend more of their money on reducing debts, leaving less to consume or invest.
The conundrum is part of the bundle of reasons–including high borrowing costs in the periphery, tight fiscal policies, stifling regulations and a shortage of Continentwide demand–why the euro zone’s recovery is likely to be grinding.
Too-slow debt reduction also leaves struggling economies vulnerable to any future bouts of global financial turbulence. The net foreign debts of Spain’s government and private sector, which come to nearly 95% of GDP, need to be continually refinanced.
“The threat is that any financial-market dislocation–a sudden stop in the willingness of foreigners to [keep buying] Spanish debt–will create chaos,” says Huw Pill, chief European economist at Goldman Sachs.
It’s a similar story in much of the euro periphery. “These debt overhangs are a sword of Damocles hanging over Europe,” Mr. Pill says.
Most periphery countries have already regained some competitiveness. But they have further to go, because they need to build up large, sustained trade surpluses to rake in the money to pay down their foreign debts.
The wage and price compression they need makes existing debts more burdensome at all levels of the economy. Spanish workers who take a pay cut to boost their company’s competitiveness, for example, will struggle even more with their mortgage.
The ECB could help by trying harder to raise Europe-wide inflation, such as by printing money and buying financial assets on a large scale. But the ECB is wary of angering Germany, which thinks monetary stimulus is bad for financial stability.
Germany could help by boosting its sluggish investment and wages. Stronger demand and inflation in the core would ease the euro zone’s internal rebalancing, and–by reducing Germany’s outsize trade surplus–also weaken the euro’s exchange rate, helping the periphery’s global competitiveness.
But Germany has made it clear that Southern Europe will have to fix the euro zone’s imbalances alone, with little help from the core to offset the drag of the periphery’s retrenchment and wage-cutting.
Europe will probably muddle through as usual, says Mr. Darvas of Bruegel. But without more inflation, “it’ll be a much longer and more painful process.”