Christine Lagarde’s deflation problem

One has to pity European Central Bank President Christine Lagarde. The last thing that she needs is for Europe to succumb to deflation as the European Central Bank (ECB) struggles to keep afloat highly indebted Euro member countries with weak banking systems such as Italy and Spain. 

Yet that is what she is now getting as the Eurozone remains in the grips of its worst economic recession in the last 90 years. Worse still, with Euro area interest rates already in negative territory, the ECB would not appear to have much ammunition left to extricate the Eurozone from its seeming debt-deflation trap.

One does not need to be a rocket scientist to anticipate that in the period immediately ahead, Italy and Spain, the Eurozone’s third and fourth largest economies respectively, will pose a particularly difficult challenge to Lagarde. In a cruel twist of fate, it was these two tourist dependent economies, with their high public debt levels and weak banking systems, that the COVID-19 pandemic chose as its Eurozone epicenter. Those two countries also now appear to be most at risk for a second wave of the pandemic. 

According to the International Monetary Fund, even in the absence of a second wave, the Italian and the Spanish economies will contract by 12.5 percent in 2020. That will see their public debt-to-GDP ratios skyrocket by year end to more than 150 percent in the Italian case and to more than 120 percent in the Spanish case. It will also result in great pressure on those two countries’ banking systems, which were only stress tested for a worst-case scenario of a 4.3 percent decline in their economies.

In the 1930s, the American economist Irving Fisher taught us the danger of deflation for highly indebted countries. He noted that deflation had the effect of reducing a country’s nominal income, both directly though lower prices and indirectly by causing people to defer their spending. That in turn reduced the country’s ability to collect taxes, which made it all the more difficult for the government to service its debt.

Fisher’s lessons about debt deflation are all the more poignant for countries such as Italy and Spain, which are struck in a Euro straitjacket. No longer able to use exchange rate depreciation to help cushion the negative effects on aggregate demand of budget tightening, these countries risk exacerbating the deflation problem if they try to engage in budget austerity policies in an effort to meet their debt obligations.

Anyone doubting that the Eurozone as a whole is heading for a deflation problem has not been paying attention to Europe’s data releases. According to this week’s Eurozone inflation numbers, over the past 12 months the Eurozone as a whole experienced a 0.2 decline in consumer prices, while both Italy and Spain experienced 0.5 percent declines. That is a far cry from the ECB’s close to but below 2 percent inflation target.

Unfortunately, in the period immediately ahead there is every prospect that the Eurozone’s deflation problem will only get worse. It is not simply that in the wake of the pandemic the Eurozone is experiencing unusually large gaps in its product and labor markets that show little sign of narrowing. It is also that that the Euro’s recent 12 percent appreciation is bound to undermine export competitiveness and to exert further downward pressure on prices through the import channel particularly considering the relatively open nature of the Eurozone economy. 

All of this would seem to leave Lagarde in a very difficult position, especially given that Eurozone interest rates are already very close to zero if not in negative territory. To be sure, in principle the ECB can step up its bond buying program to drive interest rates further into negative territory with a view to stimulating Eurozone demand and weakening the Euro. However, such an approach would risk exacerbating problems at the European banks. At a time when those banks are having to deal with a rising tide of non-performing loans, they are in no position to cope with negative interest rates.  

In recent speeches, Lagarde has called on Eurozone policymakers to support the ECB’s efforts at reviving the European economy with additional fiscal stimulus measures. One has to hope that Eurozone policymakers soon heed her call before the Eurozone gets stuck in a debt-deflation trap.

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.