Deepening Deflation Pushes Southern Europe Closer to a Debt Spiral

Eurozone slides further into a debt-deflation trap, risking a protracted economic depression in the south and slow-motion insolvency crisis

By Ambrose Evans Pritchard and cross-posted from The Daily Telegraph.

The eurozone is sliding further into a debt-deflation trap, risking a protracted economic depression in the southern countries and a slow-motion insolvency crisis. 

Headline HICP inflation dropped to minus 0.3pc in September, reaching minus 2.3pc in Greece, minus 1.1pc in Ireland, minus 0.9pc in Italy and minus 0.6pc in Spain. The core rate fell to an all-time low of 0.2pc.

“The European Central Bank has completely lost control of the inflation process. It is very serious,” said Professor Ashoka Mody, the International Monetary Fund’s former deputy director in Europe.  

The downward lurch comes as a second wave of Covid-19 threatens to truncate the fragile recovery before it has reached “escape velocity”. Madrid is back in quarantine. Paris is on “maximum alert” after the ratio of coronavirus patients in intensive care reached the danger threshold of 30pc.

The North-South divergence is toxic for the eurozone’s one-size-fits-all monetary regime. By twist of fate, those countries with the highest debt ratios have suffered the greater economic shock from Covi-d-19, pushing debt dynamics towards the point of no return. “Our concern is that Italy and Spain will be left behind,” said David Owen from Jefferies.

Large areas of the eurozone are at risk of debt deflation, a term used by Irving Fisher in the 1930s for when falling price levels cause real debt burdens to deteriorate in a vicious circle. It is extremely hard to break out of such a self-feeding process. It ends in mass default. 

The OECD’s worst case scenario sketches debt-to-GDP ratios next year reaching 229pc in Greece, 192pc in Italy, 158pc in Portugal, 152pc in France, and 150pc in Spain. “Unfortunately, this is becoming plausible,” said wen.

“We’re seeing a storm building up that may come to a head over the next six months,” said Mody. “Debts have to be repaid and a lot of new debt has been guaranteed by governments that can’t pay.”

“The ECB has already bought 25pc of Italy’s debt and they will have bought half by next year. They will own Italy and they will own Spain. There may be no technical limit but the ECB is not a normal central bank: it is a bank for a confederation of states, so there is a political limit.”

Mody said lenders have been pushed into buying government bonds and are now enmeshed in an even more dangerous doom loop than in 2012. “They are highly stressed. Their value-to-book ratio – the best gauge – tells you the market thinks debts on their books are worth just 20 or 30 cents on the dollar. The ECB is trapped into having to buy up everything to stop the banks blowing up. How is this story going to end?”

Bank of America said the eurozone will soon be flirting with core inflation rates of zero. “There is no reflation. Markets seemed to be waking up to a weak recovery. A reality check is probably in the pipeline for year-end,” it said, predicting that the ECB will be forced to double down on stimulus in December…

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