Caution: Falling Prices

Disinflation takes Europe by storm

It used to be routine. With a lock on half the Italian market, auto giant Fiat didn't think twice about raising prices several times a year. Until 1996, that is. After two summertime moves boosted average prices by a modest 1.8%, Fiat scrapped plans to put through a third hike in September. And that's not all. Thanks to discounts, the company's biggest seller, the subcompact Punto, now goes for $14,400--over 5% cheaper than it was a year ago.

Italy's car buyers aren't the only Europeans doing double takes at prices that have moved down instead of up for the first time in memory. This is the new economics of disinflation, and it's taking firmer hold in continental Europe than seemed possible even a few years ago. Much more than their counterparts in the U.S., European companies have traditionally priced their way to profits, governments have used taxpayer money to spur growth, and workers have assumed that fat pay raises would follow every economic upturn. Now, slow growth, self-imposed fiscal restraint, and unrelenting global competition have made these time-honored practices obsolete. Reflating economies through spending has become something "no one in Europe can afford," says Caroline Ven of Belgium's Kredietbank.

The structural change is overturning corporate strategies and fanning social tensions. But it's also fueling financial markets, boosting prospects for more balanced growth, and holding out the hope of lower interest rates in the future. Ultimately, disinflation could force Europe into a more competitive way of doing business that could garner it a better place in world markets.

The biggest recent surprise is Italy, one of the Continent's most inflation-prone nations. Consumer prices are rising at just 3% annually, down from 6.4% five years ago. And wage settlements have lagged behind inflation for four years running. Giorgio Bodo, Fiat's chief economist, says it is possible that Italy could see inflation levels as low as 2.2% "on a pretty permanent basis." The story is similar in Spain and Portugal, which have wrestled inflation down to just above 3% from levels near 7% four years ago. All three countries used to be derided by their northern neighbors for fiscal self-indulgence.

In some sectors, disinflation has been going on ever since Europe got hit with its worst postwar recession in the early 1990s. According to France's Usinor, Europe's biggest steelmaker, steel prices are dropping 2% a year. Mobile-phone prices are tumbling by 20% annually, and if you net out the value-added tax, computers in France sell for about the same price as in New York. Five years ago, the differential was around 50%.

But a new deflationary force has come into play since then. In their rush to join a single European currency built on German-style fiscal discipline, governments are cutting their budgets ferociously to meet the requirements for monetary union. By the end of next year, France will have nearly halved its budget deficit as a percentage of gross domestic product in just three years. Italy's deficit will have shrunk by two-thirds in four years. And Sweden, whose deficit was a crushing 12% of GDP three years ago, is expected to hack it to just 3% by the end of 1997. In deficit reduction, European governments "are doing in two or three years what the U.S. took four or five years to accomplish," says Smith Barney international economist J. Paul Horne.

For now, those efforts have helped create a grim landscape of slow growth, weak profits, and social anxiety. In late November, as French truckers blockaded French highways in a dispute with employers, calls rang out for what amounts to monetary heresy in Europe these days: devaluing the French franc against the German mark and the dollar to generate economic growth. But any boost to growth would not only be short-lived, it would also shatter a decade's worth of French progress toward monetary credibility.

CHEAPER CAPITAL. What critics are overlooking is the historic change under way in Europe's cost of capital. As free-spending governments have shifted to fiscal discipline, Germany's inflation-obsessed Bundesbank has been able to bring official interest rates to record lows. In Italy, long-term rates have dropped by five percentage points since mid-1995, to 8.5% today. "This is the first time in memory that Italian companies have a chance to fund operations at rates comparable to those in other European countries," says Andrea Azzimondi, an equity strategist at CS First Boston in London.

Lower European rates would represent a huge incentive for the kind of investment and consumer activity Europe needs. Already, Goldman Sachs International strategist Peter Sullivan calculates that the investment incentive from rate cuts to date has outweighed the drag from fiscal tightening. In fact, Sullivan thinks lower rates will boost European industrial production by 3% in 1997 and corporate profits by 20%.

Those long-term gains are one reason France's central bank isn't likely to heed the siren call of devaluing the franc. Meanwhile, there are signs that Europe's companies are learning to cope with a disinflationary world--often to the consumer's benefit. While carmakers try to maintain list prices and hang on to profit margins as thin as 2% around Europe, they're having to pile more features into cars to entice buyers. J.P. Morgan & Co. analyst Nick Snee, for example, figures that when Mercedes-Benz replaces its current $58,000 S-class with a new version in two years, the price will be little changed. But buyers will get a car with as many bells and whistles.

Another side effect of disinflation is likely to be more acquisitions around Europe. Companies that can no longer boost prices by 5% to 10% when economic growth recovers will find their hands are tied. They will be taken over by more efficient ones that can afford to extend their reach in the single European market.

Perhaps most important, Europe's new inflation landscape puts in even starker relief the labor-market rigidities and other structural woes that must be solved if Europe is to ease its competitiveness crisis. Italian and Spanish companies that could once pass high wage gains on to the consumer thanks to devalued currencies will no longer find that possible. So companies are focusing as never before on cost control, quality, and efficiency. "There's an explosion of productivity gains going on," says J.P. Morgan's Snee. Despite the current pain, that means an era of steadier growth ahead.

Before it's here, it's on the Bloomberg Terminal.