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Ambrose Evans-Pritchard writes that Europe’s slide toward deflation amounts to a “betrayal” of Southern Europe. This sounds over the top, but it is the simple truth. So let me elaborate with a picture I find illuminating.

The attached chart shows core inflation (excluding energy, food, alcohol, and tobacco) in Germany, Spain, and the euro area as a whole. As you can see, there have been two distinct eras for the euro system.

In the first era, up to the crisis, capital was flooding into southern Europe. In retrospect, this was a bad thing, but few in positions of authority were complaining at the time — oh, and in Spain it was private borrowing, not public. The result was a boom in the south, and also somewhat elevated inflation. Again, however, this was regarded as perfectly normal and good at the time. After all, you don’t expect everyone in a currency union to have the same inflation rate. Overall inflation was fine — and rising prices in southern Europe helped Germany become super-competitive and emerge from the economic doldrums it was in at the end of the 90s, without needing actual deflation.

Then the capital flows stopped, and it become necessary for southern Europe to reverse the rise in relative costs and prices that had taken place during the era of inflows. Both basic macroeconomics and the agreed-on rules of the game for the euro said that this adjustment should be symmetric with what went before — that overall euro area inflation should remain at target (or higher, says the economics, but leave that aside), with Germany running significantly higher inflation so that low inflation in the south could deliver the needed “internal devaluation”.

In fact, however, there was no rise in German inflation, and at this point it amounts to a fall. Overall euro inflation, even using the core, is far below target. And southern Europe has been forced into deflation, which is very costly and also worsens the debt burden.

And then you have the Germans saying that they dealt with their problems, so why can’t southern Europe do the same? Why, because southern Europe played by the rules, but in its time of need the rules were changed, hugely to its disadvantage.

You might ask, what would have been needed to avoid this situation? The ECB should have been aggressively expanding as soon as it became clear that inflation was sliding. There should have been a determined effort to offset fiscal austerity in southern Europe with expansion in the north. Instead, inflation and deficit obsession were allowed to rule for years; and now the situation is very close to irretrievable.

The market clearly thinks the cause is almost lost. German 5-year bonds are yielding zero; index bonds of the same maturity are yielding -0.2. That’s an implied forecast of just 0.2 percent inflation over the next five years, which means intense deflationary pressure in the south. Really not good.