Eurozone inflation hits its lowest levels for three years

Eurostat yesterday released its latest inflation statistics and the data for the eurozone provides some food for thought.

Inflation reached its lowest levels (1.1% on an annual basis) since February 2010. This might seem surprising on the surface given all the talk of a eurozone recovery and a turn around. Why hasn’t inflation followed? Well, generally inflation is a lagging indicator and therefore any recovery will take some time to feed through to prices and wages. However, as the graph below suggests, there is more at work here.

There has been significant disinflation (falling inflation but not negative inflation, which is deflation) in the eurozone and more importantly in the PIIGS. For all the talk of internal devaluation in the eurozone it has taken some time to feed through to the Consumer Price Index (CPI). Due to factors such as indirect tax increases and sticky prices and wages, it has taken some time for the impact to be fully felt – now that this is beginning to happen it is unlikely to stop immediately and could carry on for some time.

The data also shows that because of the effect described above, inflation in the PIIGS is diverging from the rest of the eurozone somewhat and particularly from the stronger countries in the north.

What does this mean for the ECB?

The FT has a couple of pieces today discussing this, calling on the ECB to do more to tackle the disinflation in the eurozone. While inflation is clearly well below the ECB’s target, the current nature of the inflation does present some issues for ECB policy.

• Firstly, there is the standard one size fits all conundrum – as inflation plummets in the PIIGS it remains stable in the north and threatens to increase as these countries post higher levels of growth. Adjusting the policies to suit these countries more could prompt unwanted outcomes in the stronger countries. Politically, it’s also worth remembers just how wary Germans are of inflation, as we highlighted recently. Finding the correct line between these two camps is incredibly tricky for the ECB.

• Secondly, while the struggling eurozone countries could use a boost in demand, the ECB may struggle to find the necessary targeted approach to do this. One measure which has been widely mooted is another long term refinancing operation (LTRO) to help boost liquidity in the market. However, as the graph above shows, there was no boost in inflation from the previous rounds, despite it totalling around €1 trillion. This is largely because the money did not filter through to the real economy and therefore did not impact consumer price inflation. Although things are improving there is still plenty of fragmentation in the market and loans to the real economy continue to fall in the PIIGS.

• This point also applies more generally in our view in terms of the tools at the ECB’s disposal. As we discussed at length here, although the ECB can do much to stop the break-up of the euro, it has fewer tools to help promote economic growth in the current circumstances, particularly in specific economies.

• In our view disinflation is not such a risk for many of these countries, in fact many need to see reductions in prices and wages to help boost their competitiveness, although it does of course have knock on impacts for their already flagging GDP growth. That said, deflation is a bigger risk because these countries have such large debt to GDP levels, which would only be exacerbated by deflation – although for countries such as Greece the need for further debt relief is already very apparent so the marginal impact of deflation is smaller.

All in all then, low inflation in the eurozone seems here to stay for some time due to the periphery pulling the average down, even if a fuller recovery eventually materialises. This will create some new issues for the ECB to deal with, however, given the divergence between countries it may well struggle to find the tools to have a big impact on this.

Are Cypriots really wealthier than Germans? And is there some great hidden wealth that southern Europe can tap into?

Yesterday, the ECB released its first survey on household wealth, which produced some surprising results – not least that Germany (on paper) seems to have one of the lowest levels of median wealth, below that of bailed out countries such as Cyprus and Greece. With the German anti-bailout mood on a high, this kind of stuff is poltically quite explosive - and it was all over German press this morning.

But what about the actual survey? Undoubtedly an important effort to increase the level of data on this aspect of the eurozone economy (important for spotting future crises) but the survey itself suffers from some serious flaws.

Much has been written about this already so we won’t regurgitate all the arguments but here are the key flaws as we see them:

• Much of the data comes from 2010, with some even going back as far as 2008. This makes cross country comparisons tricky (due to distortions from the crisis) but also means that the fall in wealth in the non-core eurozone countries will not be picked up by the data.
• Households are much larger in the southern countries – particularly with more working adults living under the same roof.
• The key distortion comes from the huge disparity in home ownership, it reaches levels around 80% in southern countries compared to 44% in Germany. Not only have house prices fallen significantly since 2010 in the southern countries but they have much further to fall. The point being that these prices remain inflated from the bubble (partly due to bank forbearance and slow adjustment), meaning that the ‘wealth’ they represent is not really there (see more on this below).
• As Luxembourg and Cyprus demonstrate the influence of large financial sectors and huge foreign investments can also have a significant distortionary effect on the figures.
• Various levels of wealth inequality across the economies also skew the figures.

Even with those points in mind though, some have argued that this survey demonstrates that there is huge wealth in the southern countries and that they should not therefore be receiving bailouts.

So why can't this 'wealth' in southern economies simply be tapped to help fund struggling governments? Well, it may not be that simple. Consider the below:

• A government decides it wants to tap into the ‘wealth’ of its citizens. Since much of this is home ownership, the best way to do this would be a property tax on the value of homes (this could equally be extended to other assets as a wealth tax) – say around 5% for illustrative purposes here.
• The government institutes the tax, but people struggle to pay because, as the survey showed, despite high ‘wealth’ they are struggling with income and cash flows. Many households are also heavily indebted and in negative equity on their mortgages.
• People across the country rush to sell their houses to avoid the impact of the tax. There is little new demand (foreigners certainly don’t want to invest), so the influx of supply cause house prices to crash.
• The tax instantly fails to receive much revenue, but the knock-on effects are worse. Many people are pushed into insolvency and default on their mortgages and other loans.
• Domestic banks (large in many of these countries) are hit hard by this and see their losses spiral. They reduce lending further, harming economic growth and forcing business to lay off more workers.
• Some banks may even need to be recapitalised, something which the government can ill afford and may possibility prompt a bailout request (what we were trying to avoid in the first place).
• Added uncertainty and depressed economic outlook push up government borrowing costs.

Admittedly, this is an extreme scenario (it also works best applying it to a country such as Spain). But it serves to highlight the point that, much of this ‘wealth’ is left over from from the previous boom. This has long been clear to many, including us, who have predicted house prices will fall further in countries such as Spain (which the Commission also said today in its report on macro-economic imbalances) – thereby eroding this wealth. Tapping into such ‘wealth’ is incredibly difficult, since when you move to catch it, it evaporates.

That banks in many of these countries have been pushing forbearance (delaying foreclosure) is further evidence – if this wealth existed in the housing market surely they would have been better of forcing foreclosure and seizing the assets (admittedly some legal questions but the broad point stands). Furthermore, public assets sales such as those pursued in Greece look like great revenue sources on paper but in practice have produced limited success, partly due to lack of demand.

There are plenty of arguments against taxpayer-backed bailouts - moral hazard, political divisiveness, debt sustainability problems, inefficiency and unfairness (to name but a few) - without over-reading this survey.

Another unwanted record in the eurozone...

Yesterday’s unemployment figures from Eurostat made a surprisingly big splash in the European press today. We say surprising since for anyone following the crisis this has been a longstanding and deeply concerning trend in the eurozone.

Eurozone unemployment reached a record high of 11.8% in November (up from 11.7% in October), while youth unemployment reached the staggering level of 24.4%, meaning almost a quarter of young people in the eurozone are out of work.

Looking deeper at the data, there are a few important points to consider:

The current trend runs counter to the majority of forecasts by the Commission and the IMF. We’ve discussed this before with regards to Greece, but it also holds for Spain, Portugal and many others. Although the pace of increases in unemployment is slowing, it has not yet stopped and with austerity set to continue across the eurozone it seems unlikely to do so at any point this year. Despite this, many of the forecasts show unemployment stabilising at or near current levels – this data highlights that this remains unrealistically optimistic.

There remains huge divergence between the stronger and weaker countries. With Austria posting unemployment of 4.5% compared to Spain’s 26.6%, the talk of the eurozone crisis being over seems rather pre-emptive. Fundamental divergences remain between the countries, with no clear mechanism for correcting or managing them yet being discussed at the highest level.

The increase in long term unemployment is becoming increasingly concerning. In the second quarter of 2012 it reached 5.2% in the eurozone, but topped 13% and 10% in Greece and Spain respectively. This has the ability to significantly harm the potential productivity of these economies and become a significant drag on (already low) economic growth. As with the wider figures it drives home the need for strong structural reforms, particularly to education and retraining programmes.

It’s also worth keeping in mind that this is happening at a time when growth is stagnating and public spending is falling sharply, meaning that the fall in standards of living for many people could be substantial – as we have pointed out before this has the potential to be a toxic mix in what is already a very politically divisive crisis.