Deflation is exactly what Europe needs now

Francois Hollande shaking hands with Mario Draghi © Getty images
Will Mario Draghi cave in to French pressure?

Oh, these long, hot sticky nights in the land of the Cathars…

There used to be a time when I enjoyed the heat and rustic charm of my little outpost in Languedocian France.

Back then the living was cheap, the work projects were plentiful, and life was good.

But the days when I spent half my time here are long gone. Today the cost of living seems higher even than in London, and the heat has an uncomfortable feel to it…

The land of the 500% tax hike

“Ahh… Bengt… You know, before this euro thing, I paid a franc for a baguette… now I pay a round euro [about seven times as much]… I sold my wine by the hundreds of hectolitres… no problem.  But today, everything is so expensive and I’m not getting the prices I need to keep up.”

This grumble from a friend of mine sums up the problem in this part of the Med. Things have simply got too expensive, and wages can’t keep up.

I mean, since I first stumbled upon my place here, property taxes are up nigh on five-fold. The basic essentials: bread, wine and cheese are similarly inflated.

To make matters worse, there are few decent projects to get involved in and the locals grumble more than ever. The rise of the right-wing in politics, the demands to get out of the euro and a general unease about the future are all too plain.

What can be done?


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Europe desperately needs a change

This is an economy in desperate need of a recalibration.

I think that all the inflation that accompanied the introduction of the euro has to be unwound – to put it another way, we need deflation.

Economists are absolutely petrified of it, but businesses, workers and even tourists round these parts could all do with a bit of deflation. We’re talking about cheaper prices. What could be better?

But it’s a bitter pill to swallow. Accepting lower prices for production and lower wages to return to competitiveness is a tough call.

What’s the choice, though? Do nothing? Tourists are already turning to eastern Europe and Latin America, or anywhere, in fact, to escape the expensive euro.

For that matter, the other key industry in this part of the world, wine production, has seen competition from exactly the same parts of the non-euro world. The grand ‘all-in-one’ currency has turned out to be an ‘all-too-expensive one’.

But it’s a political hot potato

As I write, prices are finally starting to meet economic reality in many parts of southern Europe.

About time. For years, we saw too much money chasing too few goods and services. That’s what this part of the world got used to during the noughties. An influx of northern Europeans creating demand, and outstripping supply. Prices spiralled up.

Then came the financial crisis of 2008, and along with it, a cold realisation. Now it’s a story of too many goods and services without sufficient demand.

But deflation is a political hot potato, and regaining productivity through wage compression is tough.

That’s why, right now, the head of the European Central Bank, Mario Draghi, is in an impossible situation. The demands from southern states to stop this suffering are deafening. They want inflation – and they want it now!

And Draghi is about to make a mega policy error.

The biggest policy mistake ever

Draghi is going to capitulate to the complainers, of that I’ve little doubt. He’s soon to introduce funny money to bring back the feel-good factor. But this is a proven economic catastrophe.

You don’t need to be an economist to know that this will end badly. Just look at the facts.

Southern Europe hasn’t kept pace with productivity gains experienced elsewhere in the globe. Introducing yet more money into the system can only serve to increase prices.

But it won’t rekindle demand. Au contraire – higher prices will only sap demand!

All that will happen is a bit of local inflation – and that will be at the expense of the euro. A weaker euro will serve to help those parts of Europe that are already competitive, let’s say Germany.

I’m playing this by remaining long German equities, while shorting French equities – a tactic I’ve mentioned before.

And all the while, I lament the situation. A fight to keep prices high is the last thing this part of the world needs. But it’s exactly what we’re going to get.

Dear, oh dear, oh dear!

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3 Responses

  1. 04/08/2014, Longtermyieldman wrote

    I agree that deflation would leave some European nations more competitive, especially when selling goods within the Eurozone. However, deflation raises the real value of a nation’s debt, so it worsens a country’s solvency. It is therefore a catastrophic course of action to pursue unless it is combined with swingeing cuts in public spending, tax rises and asset sales.

    The Troika has rightly pushed potential default states – Greece and Portugal in particular – down this path, with some success. However the fear is that France is too large, and politically too powerful, to be forced to deal with its debts and spending.

    For this reason, I am very negative on the outlook for the French economy.

  2. 04/08/2014, Wotan wrote

    Your article is nonsense, I am afraid. Apart from the fact that it is impossible to create lower prices “just like that” you do not understand macroeconomic workings and, obviously, you are not the only one.

    The problem is the Euro, a stillborn currency that will eventually economically destroy all the countries in the Eurozone. We need an economic dynamic, which can only be created by the interplay of individual currencies and national interest rates, i.e. only the reintroduction of national currencies and national financial sovereignty can generate the stimulus (dynamic) that is so badly needed. And yes, this would also lead to lower prices depending on the exchange rates and interest rates involved.

    You cannot have a thriving economy in Europe without countries, interest rates and currencies that compete with each other. There is no alternative to this.

  3. 06/08/2014, Ralph wrote

    Wotan seems to contradict himself about lower prices which is surprising given that he is clearly such a Demi- god of the macroeconomic world – lol

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