Euro Zone Must Defeat Deflation Ogre

Europe's low inflation rate has become the new focal point for those who believe the euro zone is doomed to disaster.

Inflation in the zone fell to just 0.8% in December, well below the European Central Bank target of "close to but below 2%." In Greece, inflation is already negative, while in Spain, Portugal and Ireland it ranges between 0.2% and 0.3%. That is fueling fears the currency area could tip into outright deflation, as Japan did in the 1990s when falling prices led to prolonged stagnation. Consumers held off purchases as they waited for goods to become cheaper, causing growth to stall and the debt burdens to rise.

The latest to lend its voice to the chorus of anxiety is the International Monetary Fund, whose chief, Christine Lagarde, last week warned that deflation was a rising risk for the global economy, which could be disastrous for the recovery. "If inflation is the genie, then deflation is the ogre that must be fought decisively," she said.

There was little doubt who Ms. Lagarde thinks needs to do the fighting. Senior ECB officials have been summoned to Washington to be presented with the IMF's gloomy forecasts and privately urged to take bolder action.

Whether the risk of deflation is really as serious as the IMF and some market economists think is debatable. The ECB itself believes that euro-zone inflation will remain below target for a long time at about 1% but doesn't believe it will turn negative.

Even if inflation in some countries does turn negative for a period, this isn't necessarily a bad thing.

In a monetary union where it is impossible to inflate away one's debts, a downward adjustment in prices may be essential to allow economies to regain competitiveness—a so-called internal devaluation. Switzerland has endured frequent periods of falling prices, as did 19th century Britain. Crucially, surveys show that euro-zone citizens expect inflation to return to 2% over the medium term.

Nonetheless, the risk of euro-zone deflation is clearly not zero—and if the ECB were a normal central bank answerable to a single government it might already be doing more to loosen monetary policy, including by embarking on large-scale asset purchases.

After all, real interest rates—the costs of borrowing after inflation—in Greece in particular but also in much of Southern Europe—are currently positive when economic conditions demand that they should be sharply negative. Critics warn that by not acting now, the ECB risks repeating the policy errors of the Bank of Japan,which didn't act swiftly enough to prevent the slide into deflation.

But this focus on the ECB misses a crucial aspect of the Japanese phenomenon. Central bankers insist that all they can do is buy time for politicians, firms and households to make the adjustments necessary to put their finances on a more sustainable footing.

It was not only—or even mainly—policy mistakes by the BOJ that held Japan back for two decades; it was Japan's failure to deliver the measures needed to allow the economy to rebalance.

It took Japan more than a decade after the bubble burst to recapitalize its banking system, during which time the economy was starved of credit. Japanese labor laws and working practices are inflexible, creating a two-tier workforce that condemns many younger workers to temporary contracts while older workers enjoy gold-plated permanent contracts.

Despite a falling population and rapidly aging society, Japan remained resistant to immigration while female participation in the workforce is very low and provision for child care poor. Worse, the Japanese public and private sectors suffer from endemic cronyism, with powerful vested interests able to resist any attack on their privileges.

The Olympus scandal in 2011, when the British chief executive of the technology group was ousted after blowing the whistle on boardroom efforts to hide substantial losses, exposed the weakness of Japanese corporate governance standards.

Yet despite the outcry, progress to improve transparency has been limited. Even today, there is so far little progress with the deep structural reforms that Prime Minister Shinzo Abe promised in return for the BOJ's latest aggressive quantitative easing program, raising concerns in the market as to whether Japan's current recovery will prove sustainable.

Some European countries have tried to learn the lessons of Japan by pushing ahead with structural measures, including a robust recapitalization of their banking systems.

In the U.K., Ireland, Spain and Portugal, there are signs that decisive action is starting to pay off. But the reality is that much of Europe, like Japan, remains hamstrung by cronyism, corruption and vested interests. It is this—far more than the ECB's reluctance to buy bonds—that poses the greatest long-term risk to euro-zone growth and prospects for deflation.

For example, in Italy where the reform is most urgently needed, Prime Minister Enrico Letta's government, like that of his predecessor Mario Monti, has so far appeared paralyzed, incapable of mustering the political strength needed to confront the vested interests that block reform.

Ominously, local politicians were able last month to block a much-needed capital raise at troubled Italian bank Monte dei Paschi di Siena to prevent it falling under foreign control.

And in France, where the economy has stalled, President François Hollande has surprised many this year with his tough talk of the need for reform. But his plans remain fuzzy and appear to depend on a corporatist bargain between vested interests among employers and trade unions.

Meanwhile, across Europe there is a clear need to reduce the costs of public administration by eliminating layers of government and bureaucracy.

Of course, if the ECB judges that the risk of Japanese-style deflation has risen, then it can and will act. It has options, even if none are straightforward. These range from providing new cheap loans to banks, to penalizing banks that hoard cash by making its deposit rate negative, to buying private- or public-sector bonds on the secondary market.

But unless the euro zone also tackles its true Japanese problem, none of these measures will make much long-term difference.

It will simply kick the can farther down the road while raising the stakes should the euro zone follow Japan into a second lost decade.

Write to Simon Nixon