Spain shows the way as Euroland deflation looms

The European data out today were not particularly good. We saw a deceleration in the eurozone economy, that when combined with the deceleration in German inflation, suggests that deflationary forces could still threaten a debt deflationary impulse in Europe if an exogenous shock hits the economy. The contrast to Britain, where manufacturing data showed economic buoyancy domestically and via exports, was striking.

Manufacturing growth in the eurozone slowed to a six-month low in May, according to the final Markit Eurozone Manufacturing Purchasing Managers’ Index (PMI). The PMI fell to 52.2 in May, down from 53.4 in April. Output growth in every country in the survey, except in the Netherlands. In France output contracted outright.

Even though this was the 11th month of expansion in the European PMI, we are still dangerously close to 50, meaning that Europe remains at stall speed, horribly close to outright recession due to any exogenous shock. In my view, the situation in Ukraine looks less likely to be that shock, but the vulnerability remains.

Meanwhile, in Germany, inflation is at a 4-year low of 0.9%. The eurozone May HICP flash estimate is now likely to come in at an aggregate 0.5% tomorrow, giving the ECB a green light to ease aggressively when it meets on Thursday. I have written on an ECB tax on reserves, QE and other easing and believe QE is the least likely measure to be implemented by the ECB straight away. However, I do believe we are likely to see some form of easing, and likely on multiple fronts.

I don’t see deflation as a ‘big deal’ and this is for two reasons. First, the empirical evidence that people hold off on purchases due to low levels of price deflation is inconclusive. There’s nothing in the empirical data that says low levels of price deflation lead to a change i consumer behavior. Second, deflation is the de facto policy choice in Europe given the emphasis on improving external demand competitiveness via an internal devaluation in the periphery. Even in Germany, there is angst about price pressures. And so, it has to be expected that a low level of consumer price deflation is the natural result from the internal devaluation policy prescription.

The real question is whether the still overindebted household sector in Europe retrenches because of existing debt obligations and low wage growth, leading to another round of debt deflation and sovereign yield decoupling due to the resulting poor macro outlook in the periphery. I am more concerned about debt deflation dynamics than consumer deflation dynamics.

On that score, it is interesting to note that the Rajoy government in Spain is pushing stimulus even though it has not met the 3% Maastricht hurdle. According to the FT, the Spanish government is planning to aid the country’s recovery via tax cuts and a 6.3 billion euro stimulus package. And note that this is deemed likely to be the last significant economic reform before next year’s general election. So it is a clear effort to buy votes.

Now, according to the EC’s latest estimates, Spain’s deficit will still be 5.6% of GDP this year, and will actually rise to 6.1% in 2015. This is before the tax cut and stimulus proposal. Spain claims it will hit the 3% hurdle by 2016, but clearly plans on doing this via the growth route instead via austerity.

Spain is coming off a Q1 0.4% GDP growth figure which is its highest level of growth since the Great Financial Crisis in 2008. And this is the third straight quarter of growth. Bad debt is also coming down ever so slightly, with the latest figures showing 13.4% of credit past due for 193 billion euros of bad debt. That number is high but seems to be declining.

The contrast in Euroland to Britain is striking. Manufacturing is now in its 15th month of expansion in the UK. And Markit says that growth is being bolstered by buoyant demand at home and abroad for Britons. The numbers are off the charts compared to Euroland, with the Markit/CIPS manufacturing Purchasing Managers’ Index (PMI) at 57 in May, down slightly from 57.3 in April. Rob Dobson, a senior economist at Markit, also said a “sharp re-acceleration” in demand for plant and equipment suggests that business investment is growing nicely as well. Of course, manufacturing is only 10% of the UK economy, but the business investment and employment side of this picture speak to robust growth economy-wide.

My prediction for this year was that Spanish GDP growth rebounds and outstrips German GDP growth. A move to a pro-growth paradigm in Spain will only help this occur – and at this point in the cycle is much more likely to reduce the deficit than a pro-austerity approach. The question at this point is whether the EC will allow Spain to take this approach given its high deficit levels.

A pro-growth fiscal paradigm is the right approach. But Europe still seems fixated on back-loaded austerity, now combined with monetary ease. The reason the ECB is being forced into further easing is because the fiscal approach is so tight and the policy path undercuts growth by suppressing wages. I don’t expect European growth to go anywhere while this approach is in place. And if it continues, the potential for a political backlash by xenophobic and nationalistic forces will increase. Spain is taking the right approach and should actually surprise to the upside.