Breakfast on 'Is the West condemned to economic stagnation?'

Breakfast on 'Is the West condemned to economic stagnation?'

Breakfast on 'Is the West condemned to economic stagnation?'

22 May 2014

With Stephen King, global chief economist, HSBC

Location info

London

Event Gallery

Issue 95 - 2014

Bulletin issue 95 - April/May 2014

Issue 95 April/May, 2014

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Bulletin issue 95
Author information

Christian Odendahl

Christian Odendahl

Christian Odendahl

Chief economist

Biography

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Chief economist
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Christian Odendahl

Christian Odendahl is chief economist at the Centre for European Reform. Christian works on European macroeconomics and growth; the eurozone, its institutions and political economy, monetary and fiscal policy; as well as German politics and economics.

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Areas of expertise: 

Eurozone, European macroeconomics and growth, fiscal and monetary policy, Germany.

Areas of expertise

Eurozone, European macroeconomics and growth, fiscal and monetary policy, Germany.

Languages spoken

English, German, Swedish

The eurozone's ruinous embrace of 'competitive devaluation'

The eurozone's ruinous embrace of 'competitive devaluation'

The eurozone's ruinous embrace of 'competitive devaluation'

Written by Simon Tilford, 10 March 2014

The euro was supposed to put an end to competitive currency devaluations, and with it ‘unfair competition’. But this has not been the case. Germany was often portrayed (wrongly) as the victim of other countries’ competitive devaluations before the introduction of the euro. But contrary to received wisdom, Germany’s real exchange rate – which takes into account differing inflation trends in Germany and its trading partners – did not rise in the run-up to the introduction of the single currency. And it has fallen steeply during the 15 years of the euro’s existence. This has handed German firms a competitive advantage of the kind the euro was supposed to eradicate. What is more, Germany is not under pressure to do anything about it. In fact, other eurozone countries are being encouraged to follow suit.

The European Commission compiles so-called ‘harmonised competitiveness indices’ for eurozone economies (see chart one). These are the member-states’ real exchange rates in anything but name. They show that Germany’s fell by almost 20 per cent between the beginning of 1999 and the end of 2011, before edging up a bit in 2012-13. The main reason for the decline in the country’s real exchange rate was very low wage increases and hence weak inflation. Spain’s (and to a lesser extent) Italy’s real exchange rates rose rapidly over the early part of the 2000s but have fallen sharply since 2008: Italy’s is now barely higher than in 1999, whereas Spain’s is up around 9 per cent. France’s real exchange rate is actually lower now than in 1999 (or in terms of the Commission’s analysis), its ‘competitiveness’ has improved. In short, the eurozone’s imbalances have less to do with its Latin members allowing costs to get out of hand than they do with Germany engineering a beggar-thy-neighbour cut in costs.

Chart one: Harmonised ‘competitiveness’ indices
(real exchange rates, quarter 1 1999 = 100)


















Source: European Central Bank

To the extent that the steep fall in Germany’s real exchange rate within the eurozone is acknowledged in Brussels and Berlin, it is typically attributed to the need to reverse the rise in the country’s real exchange rate in the run-up to the introduction of the euro. German firms, so the argument goes, needed to rebuild their competitiveness after the shock of reunification, so set about reducing costs, which led to a fall in the real exchange rate. The problem with this analysis is that it is not corroborated by the data. Chart two below shows the real exchange rates of Germany, France, Spain and Italy between 1980 and 1998. Germany’s was actually lower in 1998 than it had been in 1980. There were devaluations in France in 1983-84, and in Italy and Spain following their ejections from the Exchange Rate Mechanism (ERM) in 1992, but in each case these devaluations were largely corrective (in response to bouts of currency overvaluation) and by 1998 their real exchange rates were back to where they were in 1980. Over the period as a whole, it was Germany that had the more ‘competitively valued’ real exchange rates.

Chart two: Real effective exchange rates
(quarter 1 1980 = 100)



Source: UNCTAD, Global Development Indicators

The result is that Germany now has a hugely undervalued real exchange rate (something that neither Italy nor Spain managed before the introduction of the single currency). Why is Germany not accused of engaging in a competitive devaluation, when Spain and Italy were? After all, Germany’s real exchange has fallen sharply relative to its long-term trend, whereas the 1990s devaluations just took the lira and peseta back down to their long-term trends.

One reason is the widespread belief that eurozone countries do not have real exchange rates because they all share the euro. By virtue of sharing the euro, devaluations are seen as impossible. A devaluation is only considered a devaluation if it involves a movement in a country’s nominal exchange rates, such as when the lira and the peseta were ejected from the ERM. But when devaluation comes about as a result of low inflation (which in turn is usually the product of weak domestic demand), it is seen as a ‘competitiveness’ gain. However, the impact on other countries is the same: they face a loss of price competitiveness relative to firms based in the devaluing country and sell less to it.

Far from being considered a problem and condemned as a ‘beggar-thy-neighbour’ strategy (as was the case with Italy and Spain), Germany is lauded for its success in reducing its real exchange rate, and other countries are called upon to emulate it in order to improve their ‘competitiveness’. So, in a curious reversal the country that underwent a large competitive devaluation is not only under little pressure to reverse it but is widely regarded as a benchmark for others.

This conflation of real exchange rates with competitiveness has been damaging. A real or ‘internal devaluation’ of the kind engineered by Germany in the eurozone has harmful macroeconomic effects because it involves suppressing domestic demand and with it inflation over a long period of time. By contrast, Spain and Italy quickly returned to growth in the 1990s following their devaluations, with the result that German exports to these countries did not suffer. If Italy and Spain persevere with attempts to devalue their real exchange rates rather than Germany revaluing its real exchange rate, the result will be persistently weak demand across the eurozone, a worsening of the currency union’s already broad-based deflationary pressures and further increases in debt ratios.

While the Commission has criticised Germany’s excessive and persistent current account surplus, it has been at pains to stress that it would make no sense for the Germans to cede ‘competitiveness’. Yet it is impossible for all members of the eurozone to enjoy the unfair advantage of an undervalued exchange rate. The Commission’s implicit assumption seems to be that all eurozone economies can engineer real (or internal) devaluations, boosting their exports to non-eurozone markets and driving an economic recovery across the eurozone. But there has already been a big swing in the eurozone’s current account position, from a deficit of around €85 billion (1 per cent) in 2008 to a surplus of almost 2.5 per cent in 2013, as Germany’s surplus remained very large while the deficits of the southern members-states narrowed. It is a moot point whether the eurozone's external surplus can continue rising: it already comprises a big drag on a fragile global economy, which the eurozone in turn is increasingly dependent on. Moreover, an economy with a big trade surplus tends to experience currency appreciation because demand for its currency outstrips the supply of it, something which is now happening to the euro. A strong euro will hit demand for eurozone exports, especially the more price sensitive ones of the currency union’s southern economies.

The eurozone needs Germany’s real exchange rate to rise (that is, for the unfair advantage that Germany has carved out within the eurozone to reverse), but this will not be easy. Germany’s export-led economy – underpinned by its social partners’ ability to deliver wage restraint – combined with rapid population ageing mean that it will generate little inflation. The German economy is growing more quickly than the eurozone as a whole, but Germany’s rate of inflation is barely above the eurozone average, not least because real wages fell in 2013. More expansionary macroeconomic policies could help. First, a combination of income tax cuts and increased public investment would boost domestic demand (and hence inflation) without posing a threat to fiscal stability: the country ran a budget surplus in 2013, with the result that its debt ratio fell. Second, Germany could withdraw its opposition to the ECB embarking on aggressive monetary stimulus, which would in turn boost economic activity (and inflation) in Germany. The problem is that a fiscal stimulus of this kind would contravene Germany's constitutional requirement to balance the budget. And there is little sign that Germany will accept aggressive moves by the ECB to reflate the eurozone economy.

For its part, the Commission needs to stop defining competitiveness in terms of the real exchange rate. Competitiveness defined in this way is a zero-sum game: one country’s ‘gain’ is another’s loss. If competitiveness means anything useful it is labour productivity or total factor productivity, not the real exchange rate which can fall simply because of wage restraint depressing demand and leading to deflationary pressures. European member-states cannot rely on the ECB coming to the rescue and countering the deflationary impact of the current race for competitiveness. They should demand that Germany do the unthinkable: lose competitiveness!

Simon Tilford is deputy director of the Centre for European Reform.

French federalists propose a Euro Community

French federalists propose a Euro Community

French federalists propose a Euro Community

Written by Charles Grant, 03 March 2014

A dozen French EU experts have written a manifesto proposing the creation of a new ‘Community’ for the eurozone. The self-styled ‘Eiffel group’ makes an intelligent case for a federal, political union that would exist alongside the existing European Union. The chances of such a Community emerging are, in my view, rather small. But the manifesto deserves to be read, because the authors are serious people with first-hand knowledge of how the EU works. They include Yves Bertoncini, director of the Notre Europe - Jacques Delors Institute; Laurence Boone, an economist at Bank of America Merrill Lynch; Sylvie Goulard, a liberal MEP; Denis Simonneau, a member of the board of GDF Suez; and Shahin Vallée, economic adviser to President Herman Van Rompuy. If they get their way, the EU itself would become a second-class club with little appeal to members such as Denmark, Sweden or the UK.

The Eiffel group’s analysis of the euro crisis is similar to that of the Centre for European Reform. The authors argue, for instance, that fiscal policy has been too restrictive. And they are unhappy with the way Germany exerts leadership in the eurozone. “The current situation, where German federal bodies (Bundestag or the Karlsruhe court) hold the fate of the euro in their hands is not good for Germany, placed in a position of hegemony, nor for Germany’s partners, reduced to complying.”

But the institutional thinking of the Eiffel group makes the CER uncomfortable. Its chief proposal is for the euro countries and others committed to a “common destiny” to negotiate a treaty for a Euro Community. This Community would be about much more than the euro, covering education, training and innovation. It would invest in digital, transport and energy networks, as well as research. The group proposes new instruments to absorb economic shocks and support the most vulnerable people. It wants EU-level unemployment benefits and “partial harmonisation” of labour markets. 

The authors call for “putting an end to the ill-defined concept of subsidiarity [the idea that decision-making should rest at the lowest practicable level], a pretext for the renationalisation of policies”. And they would aim for a common external representation (though the authors say very little about what kind of foreign policy the Community should have).

A eurozone parliament would elect an executive to run the Community. That parliament’s members would double-up as MEPs. A levy on companies or a carbon tax would pay for the Community’s budget. It would borrow collectively to finance future projects, though not to cover past debts.

The Eiffel group is hostile to a greater role for national parliaments in the EU or the new Community. Nor does it want joint meetings of national parliamentarians and MEPs, as envisaged in the 2012 ‘fiscal compact’ treaty.  “The principle must be imposed that a European decision requires European control, and a national decision national control.”

The existing European Court of Justice would police the Community’s rules and enforce sanctions on those who breach them. However, nothing is said about how the European Commission – or, indeed, the entire EU – would relate to the new Community. The authors appear to think that the relationship between the euro-ins and -outs is not a problem, because they expect most of the member-states outside the euro to join it within a few years.

The manifesto’s discussion of the single market is cursory. It suggests that the single market take in countries that cannot easily join the EU, such as Albania, Moldova, Turkey and Ukraine. It assumes that Britain would be much happier if left in an outer tier consisting of not much more than the market, alongside such countries. Though they never state it openly, the authors imply that a big advantage of the new Community would be to ensure that the British cannot block further European integration.

This French manifesto was inspired by a similar German enterprise: last year the ‘Glienicker group’ of German experts drew up its own federal manifesto. The Eiffel group believes that France and Germany together have a special responsibility to manage European integration (Italy, Spain and Poland are scarcely mentioned in the French manifesto). Nevertheless many Germans will have problems with the Eiffel proposals.

Germans tend to like subsidiarity, and may baulk at the Eiffel group’s derogatory language on this principle. Similarly, they are big fans of the single market (even if they are reluctant to extend it further into services), so may wonder why these French authors seem so uninterested in it. The suggestion that the poorer Balkan countries, Turkey and Ukraine should join the single market implies that it is a slap-dash creation, rather than a construction that needs to be policed vigorously with strong rules and institutions.

The Eiffel group calls for the Community to build energy, transport and digital networks, but surely many of the most important infrastructure projects would achieve more if extended across the entire EU rather than merely the eurozone? For example, carbon capture and storage cannot take off seriously in the EU without a pan-European network of pipes to take CO2 from the places it is emitted to suitable underground burial sites (such as those which lie under the North Sea).

Some Germans will agree with the Eiffel Group that the eurozone needs to develop into a strong Community, but they will be concerned that the authors more-or-less ignore the relationship between the 28 and the 18. How could one ensure a smooth fit between the EU and the Community? What happens to the Commission? And what if the Community executive takes actions that harm the single market?

The manifesto implies that such difficulties will be resolved by nearly all the EU countries joining the euro. But that may be wishful thinking. Lithuania apart, none of the euro-outs has taken even the first steps towards joining the euro, such as entering the Exchange Rate Mechanism. In Poland both the constitution and public opinion seem likely to prevent the adoption of the euro until well into the next decade. Some non-euro countries – unlike the UK – may be willing to accept the disciplines of the euro, because they plan to join in the long run. But they will still want to ensure that the single market remains intact and that economically illiberal forces in the eurozone do not smother it.

French authors have a particular credibility problem in proposing the kinds of idea contained in this manifesto. This is because a number of senior people in France – though not the manifesto’s authors – lament the enlargement of the EU into Central and Eastern Europe, regret the waning of French influence in the wider EU, and hope to build a new, smaller club around the euro, in which France can exert significant influence. Not long ago, I heard a senior French official say that the EU was no longer useful for France, because there were too many Central Europeans in it, and because the French could no longer steer the Union.

Those outside France may imagine, however unfairly, that the Eiffel group is serving a protectionist agenda: they know that economic liberalism is, in relative terms, weaker in the eurozone than the wider EU (where the presence of Denmark, Poland, Sweden and the UK, among others, reinforces market economics). The manifesto’s reference to harmonising labour market rules and unemployment benefits in the eurozone will reinforce such fears.

As for questions of democracy and accountability, it is not only the British who argue that the European Parliament has a legitimacy problem and that national parliaments should play a bigger role in the EU. Since the CER published proposals in favour of enhancing the role of national parliaments, last October, we have had more-or-less sympathetic reactions from several governments, including Denmark, Germany, the Netherlands, Poland and Spain.

The Eiffel group has come up with an interesting and thoughtful contribution to the debate on Europe’s future. On paper, many of the authors’ ideas for a more federal eurozone make sense. They seem to imagine that the UK and others outside the euro will try to block the integration that the authors regard as necessary. But the real obstacle to these proposals lies not in London but elsewhere. The euro countries cannot hand over powers to a new Community unless their leaders can convince electorates – during election or referendum campaigns – that a federal government is desirable. So far, there is no sign that leaders in France or elsewhere are capable of that task.

In private, one of the authors has explained to me that the manifesto’s key point is that the current set-up does not work and is economically and politically unsustainable; he believes that both elites and citizens can be convinced of that point, and that they will therefore see the need for a tighter euro union. He may be right that the eurozone cannot flourish without significant reform. But politicians will find it very hard to persuade voters that a lot of powers now held by member-states should be transferred to new or existing Brussels institutions.

Charles Grant is director of the Centre for European Reform.

Dinner on 'The future of Europe's single market'

Dinner on 'The future of Europe's single market'

Dinner on 'The future of Europe's single market'

07 April 2014

With Jonathan Faull, director general for single market & services

Location info

London

Event Gallery

EU professionals find plenty of work in UK

EU professionals find plenty of work in UK

EU professionals find plenty of work in UK

By John Springford, 13 February 2014
From Financial Times

Annual report 2013

Annual report 2013

Annual report 2013

Written by Charles Grant, 10 February 2014

Britain's Conservatives must choose between sovereignty and free trade

Britain's Conservatives must choose between sovereignty and free trade

Britain's Conservatives must choose between sovereignty and free trade

Written by John Springford, Simon Tilford, 07 February 2014
From E!Sharp

What explains Europe's rejection of macroeconomic orthodoxy?

What explains Europe's rejection of macroeconomic orthodoxy?

What explains Europe's rejection of macroeconomic orthodoxy?

Written by Simon Tilford, 05 February 2014

The 1930s depression led to the birth of Keynesian economics, because the prevailing economics orthodoxy had no answers to the crisis. Keynes demonstrated that the government could, and should, intervene to correct a shortfall of demand in the economy. The rise of monetarism in the 1970s saw the challenging of the Keynesian reading of the 1930s. Monetarists argued that the 1930s depression was caused by governments failing to prevent the collapse of the money supply (the amount of money in circulation), which led to a collapse of demand rather than a collapse of demand leading to a collapse of money, as per the Keynesian analysis. Despite their differences, both camps agree that there is an indispensable role for macroeconomic policy in combating a slump.

By contrast, the depression that started in 2008, and which Europe is still struggling to emerge from, has led to the explicit rejection of Keynesian economics across Europe, and the implicit rejection of monetarism. How has a crisis borne largely of poorly run and regulated financial institutions, combined with the creation of a currency union modelled on the gold standard been used to turn the clock back on both economic theory and history? And what does it mean for Europe?

Keynesian critics of the direction of macroeconomic policy-making in Europe have long become accustomed to having their views caricatured. Their criticism of the pace of austerity is presented as a call to ‘artificially pump up demand’. This assertion rests on two assumptions: Keynesians ignore the supply side of the economy, and that Europe’s crisis is a result of government failure to push through supply-side reforms. This chorus of criticism has picked up further with signs of economic improvement in the eurozone and UK, despite fiscal austerity for the last three years.

What have Keynesians actually said, as opposed to what has been attributed to them? They argue that fiscal policy is an indispensable tool to stabilise economies suffering from a drop in domestic demand. This is especially so when interest rates had fallen to close to zero (neutering the effectiveness of monetary policy). When businesses and consumers do not want to borrow and invest even when nominal interest rates are close to zero, monetary policy is unable to stimulate demand. Keynesians also argue that fiscal policy is especially important in a currency union (where interest rates are set for the currency union as a whole rather than for the needs of individual economies). Few Keynesians dismiss the importance of supply-side policies; rather they argued that supply-side reforms will not help address a crisis of demand (and that the wrong macroeconomic policies can outweigh the potentially positive impact of supply-side policies). Finally, mainstream Keynesian economists have not said that austerity would prevent economic recovery at some point. Instead, they have said that recovery would take place at a lower level of activity, with an unnecessary accumulation of debt and the risk of deflation.

Keynesian advice was followed (up to a point) in the early stages of the crisis, and by late 2009, the European economy was recovering (see chart). However a dramatic tightening of fiscal policy in 2010 helped push the eurozone and UK economies back into a recession, which in the case of the eurozone only came to an end with an easing of fiscal austerity over the second half of 2013. Since then, European governments and the European Commission have argued that any attempt to boost demand would be at best useless and at worst damaging.

The rejection of monetarism has been less strident, but no less striking. Monetarists are sceptical that governments can affect the amount of demand in the economy through fiscal policy, but are unequivocal that central banks should prevent a collapse in the money supply. Following the launch of the euro, the ECB initially focused on two pillars when setting interest rates – an inflation target of 2 per cent and a ‘reference value’ of 4.5 per cent annual growth in money supply (M3) – but has quietly dropped the second pillar. Annual growth in M3 slid to just 1 per cent in December 2013.

The ECB is not entirely to blame for this, of course – fiscal austerity at a time of weak domestic demand was always going to hit demand hard (and so reduce inflation). But the ECB (though not the Bank of England) was slow to cut interest rates and reluctant to embrace unorthodox policies such as quantitative easing. This is all the more puzzling as the ECB is modelled to a large extent on the German Bundesbank, which was instrumental in making sure that the ECB targeted the money supply as well as inflation.

Where has this rejection of orthodox thinking led Europe? The chart below shows the relative performance of the US, eurozone and UK economies since the beginning of 2008. The US authorities have followed a pretty much standard textbook approach to the crisis, providing some fiscal stimulus to offset the weakness of demand and injecting as much monetary stimulus as possible. The US recovery has been disappointing (by US standards) but still compares highly favourably with what has happened in Europe.

What about growth prospects? Advocates of Europe’s current approach argue that the reforms being pushed have improved Europe’s growth potential. However, even the European Commission and the IMF – the architects of the European approach – expect a very modest recovery, averaging 1.3 per cent a year for the next three years (compared with over 3 per cent in the US). Many other forecasters are even more pessimistic about Europe’s prospects.

The reason for this pessimism is obvious – the damage done to the supply-side of European economies by low rates of investment (both public and private) and high unemployment (the longer someone is out of work, the less likely that person is to find a job). Far from boosting the supply side of the European economy, austerity has made structural changes less, not more likely: fiscal stimulus in the US allowed the private sector to reduce debt levels, hastening the point at which investment recovered. By contrast, the process of reducing private sector debt levels has much further to go in Europe.

Real GDP (Q1 2008 = 100)

Source: European Central Bank

What has happened to public debt? The argument for fiscal austerity was that it was necessary in order to arrest the rise in debt ratios, even if the result was a hit to economic growth. The eurozone’s ratio of debt to GDP has risen by a bit less than the US’s since the beginning of 2008 (see chart), but the US ratio is now falling quite quickly as economic recovery boosts tax revenues. The eurozone’s debt ratio did drop slightly in the third quarter of 2013, but this reflected an exceptional fall in Germany rather than the start of a trend. Moreover, in a fiscally decentralised monetary union, the aggregate debt figure is pretty meaningless. What matters in the eurozone are the debt ratios of countries such as Italy and Spain. The UK has experienced a huge rise in debt partly because it suffered a very deep recession and slow recovery and partly because of the costs of clearing up its banking sector (around 10 percentage points of GDP).

Public debt (per cent, GDP)


Source: European Central Bank

The reason why the ratio of eurozone debt to GDP is likely to keep rising is a combination of weak growth prospects and weak inflation across much of the eurozone. The ECB would never wait until inflation hit 4 per cent before it raised interest rates, yet it has allowed inflation to fall below 1 per cent, arguing that it needs time to gauge the scale of deflationary pressure. This is a risky strategy. Inflation does not need to turn negative to do a lot of damage. The lower the inflation rate, the bigger the primary budget surplus a government needs to run in order to prevent the stock of public debt to GDP rising , hastening the point at which debt becomes unsustainable. Low inflation also pushes up real interest rates, further depressing demand.

How low is inflation across the eurozone going to go? Much will depend on the international environment. A prolonged emerging market crisis would push up the value of the euro, compounding deflationary pressures in the eurozone.  The other crucial variable is Germany. If German domestic demand were to pick up strongly (lifting the country’s inflation rate), this could help offset deflationary pressure elsewhere in the currency union. Higher German inflation would help struggling members of the eurozone to regain export competitiveness relative to Germany, as well as reduce the value of the euro, boosting their exports to countries outside the currency union.

 ‘Core’ consumer price inflation (annual, per cent)


Source: European Central Bank

Greece aside, the European crisis was not a product of fiscal largesse. Mismanagement of public finances in the run-up to the crisis meant that some countries had less scope to impart fiscal stimulus than they should have done (the UK and Italy, for example). But the crisis was caused by the private sector (the failure of the financial system to allocate resources efficiently and to price risk appropriately) and policy-makers’ failure to acknowledge the implications of launching a single currency. So what explains Europe’s rejection of economic orthodoxy, be it Keynesian or monetarist?

Ideological leanings have played a part in some countries – they explain the restrictiveness of fiscal policy in the UK and Germany, for example. The British government has used the fiscal crisis to push through radical reforms of social welfare in an effort to shrink the size of the state. For its part, the German government has dismissed as ‘Keynesian folly’ calls for it to impart a fiscal stimulus to boost Germany’s lacklustre domestic demand, despite running a budget surplus in 2013.  

However, the lack of integration within the eurozone is easily the most important reason for the dramatic decline in the quality of macroeconomic policy in Europe. Eurozone governments’ inability to agree a form of fiscal burden-sharing led to highly pro-cyclical fiscal policy in some countries and has prevented rapid action to address the region’s banking sector problems. The banking systems of some economies are both fragile and too large for their governments to comfortably backstop. This pushes up the cost of capital for banks in these countries, leading to big differences in borrowing costs across the currency union and cementing differences in economic performance. Finally, the ECB has been reluctant to ease monetary policy further for fear of the political reaction in Germany (where officials and policy-makers are worried about the economy overheating and low interest rates are angering savers). Savers cannot reasonably expect a return on their savings when there is a glut of capital across the eurozone as a whole, and businesses are loath to invest, but they are an important electoral constituency, especially in fast-ageing Germany.

In conclusion, it is hard to be optimistic about Europe’s economy while conventional economic thinking and history are being ignored. ECB representatives from the countries facing the most acute deflation threat are becoming more assertive, but the central bank will remain politically constrained. Moreover, the fiscal stance across the eurozone will remain restrictive, not least because of the impact of weak inflation on deficits and debt levels and hence on the scope for governments to ease up on the pace of austerity. Modest steps by the ECB, a gradual clean-up of the banks and a very modest cyclical economic recovery are unlikely to be enough to head off the threat of deflation.  

Simon Tilford is deputy director of the Centre for European Reform.

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