Viewed from one perspective, the euro area is a minor miracle. Instead of collapsing in a heap, as seemed possible two years ago, the currency club is not just intact but has a new member, Latvia, which joined in January.
An economic recovery has been under way since last spring and appears to be strengthening. But seen from another standpoint the euro zone is an accident waiting to happen.
As inflation slips ever lower, a slide into Japanese-style deflation looks increasingly likely. That would raise an already onerous debt burden in real terms and pull down growth.
The actions of the European Central Bank will be crucial if such an outcome is to be averted. The ECB’s mission is to achieve price stability, and since 2003 it has interpreted this to mean an inflation rate over the medium term of “below but close to” 2%. Yet despite a fall in annual inflation to just 0.5% in March, the central bank was expected to hold its fire when its council met on April 3rd (after The Economist had gone to press). Previously, it had lowered the main policy rate to 0.25% in November.
One reason for the ECB to wait was that underlying inflation, excluding more volatile elements such as energy and food, has been broadly stable over the past six months, at around 0.8% (see chart). The council also sees grounds for being patient and allowing its very low interest rates to take effect. It thinks that the recovery, which started in the second quarter of 2013 after a double-dip recession lasting a year and a half, should eventually bring inflation back towards the target.
Indeed, the once-sickly euro zone is losing some of its pallor. The recovery, though feeble, has nonetheless been sustained. Output rose by 0.3% (an annualised rate of 1.3%) in the second quarter of 2013, and although growth slowed to 0.1% in the third, it picked up to 0.2% in the fourth. More important, there are signs that the pace may be accelerating this year.
Despite the crisis in Ukraine, euro-zone surveys of confidence and activity in the first three months of 2014 have been encouraging. The European Commission’s economic-sentiment indicator, based on what both businesses and consumers are reporting, rose in March to 102.4, the highest since July 2011 and a little above the long-term average of 100 since 1990; at the worst of the recession in late 2012 it had fallen to 85.8. The indicator tends to track growth, which suggests that it is picking up. That chimes with surveys of manufacturing, compiled by Markit, a data provider, which show the sector in the first quarter at its healthiest since the spring of 2011.
A reassuring feature of the recovery is that it is spreading to the once-afflicted countries of southern Europe. Germany, which remains the main engine of growth in the euro zone, is likely to have expanded strongly in the first quarter of 2014, according to the Bundesbank. But the recovery is also being boosted by a return to growth, albeit sluggish, on the part of both Italy and Spain, the third- and fourth-biggest economies in the euro zone.
The peripheral economies are benefiting from falling long-term interest rates. Ten-year government-bond yields in Italy, Spain and Portugal are now lower than they were four years ago, shortly before the Greek crisis flared up and led to the first bail-out (see chart). Remarkably, yields in Ireland, which exited its rescue programme only last December, have fallen to their lowest since the euro started 15 years ago. Peripheral yields have been dragged down both by the fall in German yields and the narrowing of their spreads over German bonds since the height of the crisis. Although the spreads are still wider than before the crisis, their tightening reflects a broader reassessment of risk: investors no longer shun peripheral Europe on fears of a euro-zone break-up, whereas they fret about emerging markets.
Despite these promising developments, there is still a concern that the recovery may have come too late and be too weak to avert the onset of deflation. Consumer prices are falling in several peripheral countries, notably Cyprus and Greece, but also now in Spain, where in March they declined by 0.2% on a year earlier.
The advent of deflation in the euro-zone periphery can be seen as part of a one-off adjustment as the crisis countries claw back lost competitiveness. But balefully high unemployment across the euro area will continue to bear down on wages, which in turn will keep prices weak. The jobless rate in February remained at 11.9%, only marginally down from its peak of 12% for much of 2013. Though unemployment has fallen over the past year from already low levels in Germany and has declined in Spain, it has risen sharply in Italy.
Making matters worse, the strength of the euro, which has appreciated by 7% against the dollar in the past year, is an endorsement the still vulnerable euro-zone economy could do without. For the time being the ECB is choosing to fight disinflationary pressures through words and threats rather than deeds. But, as Christine Lagarde, the head of the IMF, said on April 2nd, a long period of “lowflation” can be bad for growth and jobs. If inflation weakens any further, the ECB will have to act.
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