I say this because of a paradox. While deflation is supposed to be a solution to the weakness of southern Europe, it makes it harder for governments to control their debt.
A big reason why southern Europe got into trouble in the first place was that it lost competitiveness relative to Germany because in the 1990s and 2000s, prices and wages rose more in the south than in the north. For example, between 2000 and 2011 inflation averaged 1.7 per cent a year in Germany, but 2.3 per cent in Italy, 2.9 per cent in Spain and 3.3 per cent in Greece. These rises made the south uncompetitive relative to the north, and so led to big current account deficits - that is, rising foreign debt. At the heart of the euro crisis, says Jorg Bibow of the Levy Economics Institute, are "seriously unbalanced intra-area competitiveness positions".
The solution to this is for prices in the south to fall relative to the north. This is already happening; inflation now is lower in Greece, Spain and Portugal than in Germany. But because inflation is relatively low in the north, the result is very low inflation across the region as a whole.
From this perspective, deflation isn't a problem, but a solution.
However, from another perspective, it definitely is a problem. Think about the basic maths of debt sustainability. This tells us that the fiscal balance required to stabilise the debt-to-GDP ratio is a function of the initial debt-to-GDP ratio, GDP growth and interest rates.
And here's the problem. If inflation - and therefore nominal growth - falls by more than bond yields, then governments need even bigger fiscal surpluses to stabilise debt ratios. And it's highly likely that, at very low or negative inflation, inflation does fall by more than bond yields. This is because there is a limit to how far risk-free yields (ie, those in the north) can fall; there's a zero bond on long rates as well as short. And there's no reason to suppose the risk premium on southern European bonds will fall as inflation falls. The upshot is that lower inflation - at low rates - worsens debt dynamics.
A quick and rough calculation will illustrate this. Let's say nominal GDP growth averages 1.8 per cent in Italy - that's 0.8 per cent of real growth (the country's average since 1990) and 1 per cent inflation. Then with long-term nominal bond yields at 4.5 per cent, a primary budget surplus of 3.9 per cent of GDP would stabilise the debt-to-GDP ratio at 146 per cent. With the country now running surpluses of over 5 per cent, the debt-to-GDP ratio can therefore fall.
However, if nominal growth falls to 0.8 per cent (implying zero inflation), then bond yields of 4.5 per cent mean that the country needs a surplus of 6.8 per cent of GDP to stabilise the debt ratio. That means even more austerity - and permanently so.
This tells us why Italy's new prime minister, Matteo Renzi, is so keen to reform taxes and the labour market; the country needs higher growth to stabilise debt.
But it also tells us that the euro crisis hasn't gone away. In theory, one way to help the south would be if the north had more reflationary policies; higher demand in the north would allow the south to export more, and would allow it to regain competitiveness not by local deflation but by higher inflation in the north. But there's no mechanism to generate this, and strong resistance in Germany to doing so: savers there might well ask why their wealth should be eroded by inflation just to bail out Greeks and Italians.
And this is why deflation is such a nasty prospect. It threatens to reignite the debt crisis by exposing the tensions within the euro area.
