Catastrophic Stability, by Paul Krugman, in NY Times: I look a fair bit at bond market “breakevens” — the difference in interest rates between regular bonds and inflation-protected bonds of the same maturity, which give a measure of inflation expectations. It’s not a perfect measure by any means, since there are issues of risk and liquidity, and anyway what bond investors expect isn’t necessarily reasonable. But breakevens do give a quick read on the issue, and can be helpful in thinking about where we are.
So, let’s look at German breakevens:
The market seems to expect price stability for Germany — an inflation rate of 1 percent or so over the next 5 years. And that has a clear message: it’s signaling catastrophe for the euro.
Why? I tried to lay this out a while ago.A reasonable estimate would be that Spain and other peripherals need to reduce their price levels relative to Germany by around 20 percent. If Germany had 4 percent inflation, they could do that over 5 years with stable prices in the periphery — which would imply an overall eurozone inflation rate of something like 3 percent.
But if Germany is going to have only 1 percent inflation, we’re talking about massive deflation in the periphery, which is both hard (probably impossible) as a macroeconomic proposition, and would greatly magnify the debt burden. This is a recipe for failure, and collapse.
Another way to say this is that the euro is going to have a chance of working only if the ECB delivers much more expansionary and, yes, inflationary policies than the market now expects. If you don’t think that’s a possibility, say goodbye to the euro project.