Japanese-style deflation edges closer to Europe, suggests Signet Group’s Noel Mills

Noel Mills, chief economist at Signet Group has outlined th danger of Europe falling into the same economic trap as Japan over the past two decades, with rising real GDP, but falling nominal GDP.

Two key areas of concern have served to undermine investor confidence in recent months. First, there is growing uncertainty about the sustainability of US economic growth and there is still no bipartisan agreement on fiscal reform. And we all know that it is in the nature of US politics that difficult decisions on the federal budget deficit have been put back until after this year’s presidential election.

The second concern relates to the on-going economic paralysis in Europe and the failure of its politicians to move beyond their lop-sided policy response of fiscal austerity as the cure-all for the continent’s troubles. The common denominator on both sides of the Atlantic is the need for fiscal consolidation. The difference is in the timing and pace of the consolidation.

At the height of the banking crisis four years ago there was general agreement that both monetary and fiscal policies should be used to the full to head off a threatened global depression on a par with the 1930s. There is much less agreement now on what needs to be done next.

Unorthodox monetary policies have been layered on top of unprecedentedly low interest rates, but to uncertain effect. The heavily indebted industrial economies are stuck in a classic Keynesian “liquidity trap” made worse by continued bank deleveraging and the good intentions of regulators bent on preventing a repeat of the banking crisis.

The reality is that central banks were forced to expand their balance sheets precisely because those of the private financial sector collapsed. In much the same way, governments picked up the slack when private spending fell.

Time will be the ultimate judge of these policies. Success will be a function of how skilfully central banks rein in their balance sheets and how well governments bring their rising indebtedness under control. In the meantime, we can measure success or failure by the extent to which monetary and fiscal policies have helped to generate economic recovery without pushing up inflation to undesirable levels.
On that basis, the more permissive policy mix of the US has to date been the more successful. The more conservative European approach to both monetary and fiscal policy has so far resulted in weaker more unbalanced growth accompanied by a high and rising rate of unemployment.

Admittedly, a large part of the difference derives from the nature of the two economic blocs. One, the US, is a textbook “optimal currency area”. The other, the eurozone, manifestly is not. The US is a single economic and political entity with a large federal budget, good internal labour mobility and centralised banking regulation. Despite its best efforts in the shape of a revamped Stability and Growth Pact, Europe is still a long way from full fiscal union and, by inference, political union.

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