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Déflation: le déclin de l’euro?

The economic trap is closing relentlessly on the Eurozone. Everyone was aware of the Japanese deflationary scenario. It was even condemned as the most dangerous economic hazard. Yet the Eurozone is taking this deadly route because of a lack of vision and political obstinacy. The descent into the economic abyss will be prolonged and frightening, as Europe has lived with the assumption of growth for nearly seven decades.

Deflation is much worse than inflation. After all, you can fight inflation with deliberate interest rate hikes and price controls at the cost of a weaker economy. Deflation, on the other hand, is a shocking capitulation, as it renders conventional monetary policy ineffective. It brings unemployment, economic stagnation, and higher real interest rates (i.e. after subtracting inflation) on borrowings (public and private) that inhibit investment. It often causes a liquidity trap to form through the accumulation of precautionary savings despite very low interest rates. To illustrate, the velocity of money, i.e. the rate at which banknotes "circulate" in the economy, has declined by 50% in the past 5 years. It is therefore impossible to increase competitiveness and to cut public deficits in deflationary periods.

There are numerous reasons for the deflation, including deindustrialisation and a costly welfare state whose debts will have to be repaid. For too long, Europe believed it could continue with an industrial economic model whereas the market economy is now based on flexible production factors and, increasingly, fast-moving pockets of growth. Governments can no longer perform the same redistributive functions as were permitted by post-war reconstruction and a manufacturing economic model.

There are two more reasons.

The first is serious political short-sightedness. After the 2008 crisis, it was clear that the real economy would suffer a terrible shock. But the 2008 crisis was not just about the sub-prime mortgage collapse. It also marked a fundamental shift in society. The market economy adopted global free trade rules justified by the opening up of markets and the Internet. Thus 2008 witnessed the harsh initiation to Anglo-Saxon-style capitalism, an economic model that has now become a growth standard.

The 2008 shock led governments to activate economic stabilisers and also recapitalise and nationalise banks. Rising government debt was unavoidable, especially as the shock of ageing populations caused spending on pensions to spiral. While government debt skyrocketed for legitimate reasons, an alarming truth was revealed: government debt had for decades financed running costs rather than investment fostering collective growth.

We have therefore been living at the expense of future generations. Although some politicians like Jacques Delors had campaigned for major infrastructure projects to underpin the European economy, nobody listened to them.

Confronted with growing public debt of differing characteristics between Eurozone member countries, the European authorities opted for harsh austerity policies. It was clearly a big mistake caused by an apparently dyslexic reading of Keynesian theory. In the 1930s, Keynes urged countries with deflation not to make matters worse by implementing austerity policies. Nobody listened to him, even though deflationary policies failed (Laval in France, Hoover in the United States, Brüning in Germany, etc.), sowing the seeds of military conflict. In the majority of cases, failed austerity policies also ended in devaluation (the French Popular Front of 1936 and the Van Zeeland government of 1935 in Belgium).

Fiscal contraction is now endorsed by a European pact that will inevitably cause contortions in economic management. The pact requires a reduction in excess public debt of 5% a year to reach a public debt to GDP ratio of 60%. The 60% figure is nothing new as it was a qualifying criterion for Eurozone accession in 1999. This rule is now paired with the so-called "golden" rule of a "structural" deficit (exceptional economic circumstances excluded) of 0.5% of GDP. Deprived of an external currency devaluation capacity, Europe is imposing an internal devaluation by way of the fiscal contraction and wage moderation demanded in the austerity programmes under the fiscal pact.

The euro is the other additional reason for the deflation because of the project's now alarmingly apparent design flaws. The end result of the Northern countries' competitive disinflation logic is deflationary recession. With the euro basically a deflationary currency, we are falling into a Japan-like trap of currency strength without inflation or growth.

German is imposing its monetary sovereignty on the Eurozone. An obstinate Germanic policy of inflation avoidance, at odds with collective solidarity, is being pursued at the same time as quantitative easing in the United States, Great Britain and Japan. Deflation will unfortunately make public debt unrepayable. I fear that without inflation, we will exit this public debt crisis by write-offs of Southern European countries' sovereign debt.

There is another risk now: high real interest rates. All the central banks have said they would keep interest rates at floor levels. That only applies to short-term rates, as long-term yields are determined by the markets. We need to be ready for this. There are several reasons why long-term yields will rise: the gradual completion of quantitative easing in the United States (equivalent to an artificial 2% short-term rate cut), emerging market currency falls, jumps in inflation, etc. Deflation would intensify the rise in real interest rates with catastrophic consequences for Europe.

What should we do? There is no ideal solution. An inflationary shock is needed. This would mean sharply depreciating the euro by truly large-scale quantitative easing or the massive refinancing of weaker countries' public debt (equivalent to new money creation). In other words, since we are in a Japanese scenario, we need to take our cue from present-day Japanese monetary policy. Inflation would, of course, trigger a rise in nominal interest rates. But we can hope that governments have sufficient control over credit channels to temporarily check inflation. An inflationary shock alone will not be enough. The realisation is needed that a return to a balanced budget is not the answer when an economy is contracting. Major infrastructure projects to modernise Europe and not just individual nation states would be a better solution. Europe is not yet ready for this and probably never will be. It is bracing itself for a lean decade. There should be no illusions. Europe’s currency and social order will not emerge unscathed from deflation. It will mean the downfall of the euro, no longer a common European currency but a German-inspired single currency, i.e. a currency too strong for many ailing economies.