For the last two years, the inflation rate in the eurozone has decreased steadily and now stands at just 0.4 per cent.

True, the eurozone is not a homogenous economy: core inflation in Germany is stable at above 1 per cent, but in France it has slipped below 1 per cent; whilst core prices have stabilised in Portugal and Spain, and have been falling in Greece since 2011.

Still, the overall slowdown in the euro area inflation rate remains spectacular, and is feeding into fears the region will succumb to deflation, much like Japan in the 1990s.

At the time, the Japanese economy was faced with a series of shocks, with the stock and the property market bubble bursting, followed by the Asian crisis causing it to slide into deflation in which the decline in the general level of prices and wages became self-reinforcing.

The high level of the private-sector debt to income ratio at the time was a big contributing factor, with nominal income down, the debt burden kept increasing, thus further dampening demand. The intensity of this debt-deflation is why it took more than 20 years for Japan to (maybe) finally put an end to the drop in the general level of prices.

Limiting shocks

Like Japan, the European economy has been hit by several major shocks. After several years of deleveraging, the weight of household debt is still high, and government debt ratios have swollen as public finances have been used by European governments to limit the shock of the financial crisis.

Some similarities with Japan are thus quite striking. This is the case of Spain, in particular, where nominal growth has tumbled from nearly 8 per cent on average since the early 2000s to 1 per cent since the start of the 2010s, with GDP prices stagnating since 2008.

Though less pronounced for the eurozone as a whole, these trends are very similar to those seen in Japan. In just a few years, nominal growth has flagged from 4 per cent to less than 2 per cent, and while the evolution in GDP prices is different from Japan’s, it cannot be denied that they too have slowed.

The same is true for wages. The correction in the price competitiveness gaps which has started within the eurozone have clearly dragged down wages in peripheral countries. In Spain, hourly wages have barely budged since the end of 2011, but have been falling in Portugal since 2011 and in Greece since 2010.

It would be worrisome indeed if such an adjustment were to continue. And while this correction appears to be drawing to a close in Spain, Portugal, and Ireland, this is far from true in France and Italy. In both countries household debt is much lower and the risk of debt-deflation is reduced accordingly.

Lowering deficits

Given the limited options in terms of monetary policy, the role of fiscal policy may well become a determining factor.

The 2 per cent rise in the VAT rate in 1997 before the Asian crisis erupted, for example, was decidedly a contributing factor that sent the Japanese economy into an extended period of deflation.

The initial aim of lowering the budget deficits of eurozone member states, at any cost, also encouraged the development of deflationary pressures. Today, after four years of sometimes harsh fiscal tightening, the weight of public-sector debt has stopped climbing almost across the board.

There are still considerable efforts that need to be undertaken in some countries to bring debt ratios back down to a reasonable level, but even so, fiscal restriction will diminish in the coming years. Deflationary pressures at work in this area should therefore begin to ease.

Deflationary grip

Sources of deflationary pressures in the eurozone abound. From the deleveraging process in the private sector after the subprime crisis hit, to the correction of competitiveness gaps bringing wages down or to the rapid re-balancing of budgets. Beyond a shadow of a doubt, one country – Greece – is already in the grip of deflation (widespread drop in prices and wages), while others such as Spain and Portugal are teetering on the edge.

That said, deflation cannot take root in the eurozone without affecting the large majority of its constituent economies. The good news is that few countries have accumulated all the factors (high private and public-sector debt, downward pressure on wages, etc.) liable to trigger true deflation. In particular, excess business investment, which was rampant in Japan, is largely absent in most eurozone countries.

While the accumulation of factors at work in Japan are largely absent from the eurozone, it will nevertheless continue to struggle with dangerously low inflation and growth in the coming years. This will leave it particularly vulnerable to another shock. Under these circumstances, it is however more up to the governments themselves rather than the ECB to prevent deflation.