Early warning tremors in the European economy

A few years ago, a number of prominent Italian seismologists were subject to public opprobrium for having failed to predict an earthquake in the Italian town of L’Aquila despite a series of very clear early warning tremors. One has to wonder whether something similar is not happening today in European policymaking circles concerning the eurozone economy. Since despite an ever-increasing series of early warning signals that the eurozone might be heading soon for another round of its sovereign debt crisis, European policymakers are making little change to their policy approach to avert a major debt crisis that could lead to the eventual unraveling of the euro.

Among Europe’s most recent economic tremors has been the growing evidence that the German economic recovery has now run out of steam. Indeed, the most recent German economic data would suggest that the eurozone’s economic locomotive is now likely to have succumbed to a triple-dip economic recession in the third quarter of 2014. Should Germany in fact experience another recession, there is little prospect that the rest of Europe will manage to get itself out of its present economic funk since it is so dependent on a healthy Germany for its exports.

{mosads}Germany’s most recent economic slowdown would seem to be all the more concerning for the eurozone since the forces that have caused the German economy to slump are not likely to go away anytime soon. That would certainly appear to be true of the escalating sanctions resulting from the West’s standoff with Russia over Ukraine, the ongoing Middle Eastern geopolitical uncertainties and the significant economic slowdown in a number of major emerging market economies.

Yet another early warning sign that Europe could very well soon be heading toward the next round of its sovereign debt crisis is that it appears to be well on the way to outright price deflation. While the European Central Bank (ECB) does have an inflation target of close to 2 percent, the overall European inflation rate has already decelerated to 0.3 percent. Meanwhile, most countries in Europe’s highly indebted economic periphery are now already experiencing outright price deflation. Sadly, there is every prospect that Europe will soon experience a real deflation problem. It will do so as its economy experiences a triple-dip economic recession at the very time that its unemployment rate is already not far from its post-war record highs.

The prospect that Europe could be heading for outright price deflation should be setting off alarm bells for its policymaking establishment. The public debt levels of most countries in the European economic periphery are already very high, as epitomized by an Italian public debt level of close to 140 percent of GDP. Such debt levels are very difficult to bring down to more sustainable levels at the best of times. However, in the context of an economic recession, which undermines those countries’ public finances, and of outright price deflation, which increases that debt burden, those debt levels could be well-nigh impossible to reduce. One would hope that European policymakers appreciate how vulnerable this leaves the European economic periphery to the prospective tightening in global liquidity conditions in the period ahead as the Federal Reserve starts the process of normalizing interest rates sometime next year.

Yet another early warning sign for Europeans about debt financing problems ahead is the austerity fatigue that now characterizes the European economic periphery. After many years of austerity and economic malaise, countries in the European periphery are increasingly reluctant to persevere with budget austerity and painful structural economic reform. This explains why Greece, Ireland and Portugal have all been so keen to exit their International Monetary Fun (IMF)-EU adjustment programs. What should be raising red flags in Europe is that without a commitment to economic adjustment programs, the European Central Bank will be in no position to bail out those countries should the need arise when market financing dries up on them.

With so many early warning signals flashing and with global liquidity conditions soon to tighten, one would think that European policymakers would be moving rapidly to change policy course toward more expansive fiscal and monetary policies in an effort to get the European economy moving again. Sadly, there is absolutely no indication of any such movement. Indeed, in response to ECB President Mario Draghi’s call for some easing in European fiscal policy, the German policymaking establishment is insisting that Europe sticks to its course of fiscal rectitude, monetary policy orthodoxy and structural economic reform. This has to bring to mind those hapless Italian seismologists who some years ago failed to warn of an impending earthquake despite the all-too-many early warning clues that were pointing in that direction.

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.