Europe's Deflationary Future
By the beginning of this year, many European economies were becoming increasingly confident that their efforts to defeat the growing threat of deflation in Europe were beginning to bear fruit. Thanks to a weak euro and an increase in domestic demand, inflation rates had slowly trended upwards in the latter part of last year as well as the first part of this year. However, deflationary pressures have worsened once again across Europe as low oil prices and a new slump in domestic demand has again pushed price levels downwards. For more than a decade, we have been warning that Europe would face long-term deflationary pressures, and once these surfaced in the wake of Europe’s recent economic crises, these deflationary pressures have proven very difficult to eliminate. As such, Europe now faces a long struggle to reduce these deflationary pressures and this struggle will likely prove costly for Europe.
Prior to last month, inflation rates in Europe had been slowly trending upwards, with deflationary pressures easing slightly. However, the Eurozone group of countries fell back into deflation last month (-0.2% year-on-year inflation rate), a development that caught policy makers in Europe by surprise. Two regions in particular are suffering from significant deflationary pressures. First, southern Europe’s crisis-battered economies have been stuck in a deflationary cycle for a number of years now and prices continue to fall across this region as domestic demand levels remain very weak. Second, many central and southeastern European economies are also trapped in a period of prolonged deflation, with low demand levels also playing a key role there. Meanwhile, there are mounting concerns that many of the northern European economies that have thus far not suffered such severe deflationary pressures are also on the verge of a period of even greater price declines. In fact, inflation rates across much of Europe have been in decline over the past four years, with deflationary pressures becoming particularly acute over the past 18 months, with the upturn in prices late last year proving to have been short-lived.
The obvious comparison for Europe is Japan, where deflationary pressures have been firmly in place since the early 1990s. While pre-1990s Japan had a wealthier and faster-growing economy than the Europe of the 2010s, there are many other similarities, including shrinking working- and consuming-age populations, and currencies that have largely been overvalued. This comparison should concern Europe, as since deflation has taking hold in Japan, that country has fallen from the wealthiest developed economy in the world to one that has been surpassed by a majority of the world’s other developed economies. Moreover, deflation and the continued weakening of Japan’s domestic market have left it ever more dependent upon export markets for its growth. The key challenge for Japan in the 1990s was the rise of new exporting rivals, particularly China and other East Asian exporters (Europe’s key external challenge is lower levels of global economic growth). Unfortunately, Japan’s continued demographic decline suggests that deflationary pressures will remain firmly in place there, as the recent efforts by the government Prime Minister Shinzo Abe to end deflation were successful for only a brief time.
As we know, Japan’s economic and political power has been dramatically reduced by the country’s struggle with deflation and this must concern European leaders. Both Europe and Japan have many traits in common that make the fight against deflation particularly difficult. First, both sides are in the midst of severe demographic declines, with southern and central European countries having demographic profiles very similar to Japan’s. Even northern Europe’s population growth rates trail behind that of most other countries in the world. Meanwhile, both Japan and Europe have currencies that remain over-valued, despite their recent depreciations, and this is keeping import prices relatively low. Considering Europe’s increasing concerns about its diminishing role in the world, a long-term battle against deflation must be disconcerting. Given the fact that Europe’s neighborhood has become a whole lot more dangerous in recent years, the potential impact of long-term deflation on Europe’s economic power is a serious threat to the stability and prosperity of Europe. However, defeating deflation could prove to be much more difficult than European leaders expect and it will take a concerted effort to win this battle.