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Deceptive eurozone calm foreshadows new storms

ECB success produced complacency, and politicians failed to introduce vital but painful reforms

THE MARKETS remain preoccupied, almost obsessed, with the timetable of Federal Reserve tapering. But looming eurozone threats are becoming ominous.

The US government shutdown and fears over debt default are now behind us. The longer-term damage to US credibility could be serious, but the short-term impact on the economy has so far been minimal. In the face of better-than-expected US figures for jobs and GDP, hopes that the Fed would be forced to postpone tapering into 2014 have faded.

A December starting date for tapering is again a realistic prospect, but not a certainty. Some Fed officials are worried that inflation is too low and are afraid of deflation. These fears are probably unjustified. But Janet Yellen, who succeeds Ben Bernanke as new Fed chairman, will face serious tests very early in her new career.

Political failure
Since the end of 2011, the European Central Bank has been remarkably successful in reducing risks of a disorderly euro breakdown. In spite of recurring problems in the periphery, forceful ECB measures succeeded in easing menacing tensions. By providing ample and cheap liquidity to commercial banks, and promising to buy sovereign bonds subject to strict conditions, the ECB reduced threats of crisis outbreaks, and bought precious time. But success produced complacency, and politicians failed to introduce vital but painful reforms.

The euro’s structural problems – a one-size-fits-all official interest rate, and inability to use the exchange rate as a mechanism of adjustments – remains a source of chronic tension. Disparities between strong and weak eurozone countries have widened over the years, and potentially explosive strains have been made worse by the sharp rise in the euro over the past 12-15 months.

The calmer environment produced by the ECB’s success accentuated the euro’s strength, and this undermined competitiveness. Fears of eurozone deflation worsened when the annual rate of consumer inflation fell to 0.7% in October 2013, well below the official target of “just under 2%”. Although this ominous background has not disturbed the euro’s calm, the ECB shocked the markets by cutting its key policy rate from 0.75 to 0.5%. But the decision was not unanimous, and was strongly opposed in Germany.

It is easy to exaggerate fears of deflation. Recent figures show positive annual inflation rates in all the major economies: 1.2% in the US, 0.7% in Japan, 3.2% in China, 0.7% in the eurozone and 2.7% in the UK. Only Japan suffered prolonged deflation.

Aggressive policies known as “Abenomics” have succeeded recently in pushing up Japan’s inflation rate, although reaching the 2% target will be a protracted process. However, Japan’s deflation was historically very mild, and the damage it caused is being overstated; the country’s long-term stagnation is mostly due to lack of structural reforms and banking inefficiencies. At the other extreme, there is no risk of deflation in the UK, with inflation persistently above the 2% target for the last four years. In the US, where inflation has fallen in recent months, and is now well below the 2% effective target, there are some concerns over the possibility of deflation, but such fears are not really justified.

Devastating deflation
The eurozone is the only global region where deflation, or even a prolonged period of very low inflation, could cause truly devastating damage. Germany, with its robust economy and low jobless rate, will not be seriously affected by modest price falls. But periphery countries, including Italy and Spain (the third- and fourth-largest eurozone economies, respectively), may be badly hit.

Deflation will increase the debt burden, which is already excessive. Threats facing banking sectors in weak countries will escalate without an effective banking union. The lack of competitiveness, which is already acute in the periphery, will worsen, unless falling prices can be matched by falls in nominal wages, and this will be difficult to secure without industrial and political conflict in countries with powerful unions. Eurozone unemployment, which at 12.2% is already high by international standards, will increase further in these circumstances, adding to the risks of strife. Greece and Spain, with jobless rates in excess of 26%, are most exposed, even though Spain is now making progress. A major euro crisis is not inevitable, but dangers are increasing. Eurozone politicians must deal with the fundamental issues. They cannot always rely on the ECB to produce yet another short-term palliative.

US performance, although mediocre by historical standards, is slowly improving. GDP growth in Q3 2013 was 2.8% annualised, better than expected, but the headline figure was boosted by a large increase in inventories that may dampen output in the next quarter. The job figures for October were surprisingly strong, with a monthly rise of 204,000, much larger than the expected increase of 120,000. Although the unemployment rate edged up marginally from 7.2 to 7.3%, it is clear the impact of the US government shutdown was smaller than feared. Upward revisions to the August and September figures added 60,000 jobs to the total, reinforcing the cautious optimism over the outlook. With the housing market improving, albeit at a slower pace than earlier in the year, the US economy is sufficiently robust to cope with early tapering.

UK GDP growth accelerated to 0.8% in Q3 2013, after 0.7% growth in Q2, which is stronger than in other G7 economies including the US. But longer-term comparisons are less flattering. UK output is still 2.5% below its pre-crisis level in Q1 2008. In Germany and the US, GDP is already above pre-crisis levels. The UK labour market remains robust and employment is up, but productivity has fallen in recent years. The MPC is relying on forward guidance to persuade businesses and consumers that interest rates will stay low for an extended period. But falling unemployment may force the MPC to tighten policy earlier than they initially intended.

David Kern of Kern Consulting is chief economist at the British Chambers of Commerce. He was formerly NatWest Group chief economist

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