Taking the Shine Off European Growth
Economic advances in the eurozone should be taken with measured optimism, given past trends.
August 12, 2015 | 09:15 GMT
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Forecast
- It is unclear whether the apparent improvements in some European economies will be sustainable.
- The optimism surrounding these economies could actually be dangerous if it bleeds into the markets.
- Pressure will continue to rise on Germany to subsidize other eurozone countries.
Analysis
While
the world's attention has been focused on the drama in Greece, a
different narrative has been forming around the rest of the eurozone
economy. It is a story of moderate recovery and return to growth, and it
carries the message that Europe, which taken together is the world's
largest economy, has finally turned a corner.
Germany,
the Continent's economic driver, has continued to record high export
numbers and low unemployment, and the current account surplus, prided by
Germans, was a hefty 7.4 percent in 2014. Spain, the monetary union's
fourth largest economy, is growing beyond all expectations, and the Bank
of Spain recently raised its growth forecast from 2.8 to 3.1 percent
for 2015. Considering how difficult the past seven years have been for
Spain, these numbers are indeed impressive. Even France and Italy,
Europe's second and third largest economies, appear to be shaking
themselves from their torpor and seem poised to register growth of 1.3
percent and 0.7 percent respectively, according to World Bank
projections. (In 2014, France grew by 0.2 percent and Italy shrunk by
0.4 percent.) Meanwhile some of Europe's smaller states such as Ireland
and Portugal, which have caused problems for the union in the recent
past, have also seen marked improvements in their headline figures.
Ireland has stood out in particular, boasting Europe's fastest growth
rate in 2014. These positive numbers, however, raise the question of
whether Europe's recent growth is truly sustainable. The years between
the birth of the euro in 1999 and the 2008 economic crash were also
marked by a great deal of growth. But this growth came at a huge cost:
The financial crisis revealed that the boom had been fueled by credit,
which now weighs heavily on Europe's balance sheets.
But
things might be different this time. There are temporary circumstances
that are at least partly to blame for the recent boost. In the second
half of 2014, the price of oil fell
by half to $50 per barrel, and though it has since fluctuated upward,
it recently dipped back below the $50 mark. For oil importing countries —
most of Europe — a low oil price acts in the same manner as an
across-the-board tax cut. Companies see transport costs slashed and
consumers find they have more money to spend because of low prices at
the gas pump. In addition to this price drop, 2014 also saw European
Central Bank President Mario Draghi drop hints that he intended to undertake a policy of quantitative easing,
a promise he fulfilled. The markets prepared by selling euros and
buying government bonds. The resulting weak euro and high demand for
government debt has had twin positive effects for eurozone countries:
The weak currency increased the global competitiveness of exports, while
low interest repayments took some pressure off Europe's heavily
indebted nations. Neither low oil prices nor quantitative easing are
likely to disappear in the immediate future, but it is important to note
that both are short-term stimuli that cannot be relied upon in the long
run (though it is still possible that this could be the new normal for
oil prices).
What Spanish Unemployment Conveys
Spain's recent growth, meanwhile, becomes much more complex when studied closely.
The 2012 bailout of Spain's banking system — like the bailouts in
Ireland, Portugal, Cyprus and Greece — came attached to various
structural reforms designed to increase the country's overall
competitiveness. In theory, these measures would allow the eurozone
periphery to compete with the German export engine. Spain has managed to
lower its wage growth to ultimately negative levels, a striking feat
when compared to France and Germany where wages continued to grow. The
idea underpinning the reforms is that Spain's membership in the eurozone
constrains its ability to devalue its currency, so it must instead
devalue its inputs — in this case, wages — to regain competitiveness,
including against its eurozone peers. But Spain's recent growth does not
seem to have been achieved through the intended export-led model; it is
instead being driven by domestic demand.
Spain's
trade balance, having reached a surplus in 2013, has now dipped into
deficit, meaning that Spain is now importing more goods and services
than it is exporting. By means of comparison, Germany, whose economic
model is the ultimate goal of reform attempts, had a trade surplus of
7.5 percent of gross domestic product in 2014 while Spain had a 1.7
percent deficit. A closer look at some of Spain's other recent successes
is also sobering. Though it is true that Spain's unemployment has
dropped to its lowest level since 2011, unemployment is still at 22.4
percent, the second highest in Europe by far. Moreover, a quarter of the
jobless are long-term unemployed, and Spain's overall youth
unemployment still hovers just under 50 percent. The combination of high
long-term and youth unemployment reflects a young generation that has
missed out on the formative post-university years of work. Assuming
Spain does manage to continue creating jobs for its unemployed, which is
a big assumption, it might be hard to find these lost youth — who are
often called "ni-ni's," meaning neither-nor, since they neither work nor
study — any kind of meaningful employment.
Furthermore, the political driver of Spain's economic trajectory
is likely to disappear soon. The ruling People's Party is facing
elections at the end of this year and has relaxed some of its fiscal
austerity to help build momentum. Such fiscal laxity is unlikely to last
far into 2016 if the party retains power. (If a leftist coalition that
includes the Spanish Socialist Workers' Party and Podemos wins, spending
will likely increase but will soon run into fiscal barriers.) The fact
is that Spain's underlying numbers still look very weak. Spain has a
debt to GDP ratio of 98 percent, high private debt levels and a 2014
budget deficit of 5.8 percent, which is far above the 3 percent required
by the European Union. This means that the country has little room to
stimulate growth through more credit, which again raises questions about
the sustainability of its current expansion. Shaky growth in Spain also
has ramifications elsewhere: Portugal's exports have recently been
boosted by Spanish demand, and thus could decline as Spain slows down
again in 2016.
Broad Uncertainty
Among
the eurozone's "Big 4" — Germany, France, Italy and Spain — the picture
does not look any rosier. If Italy is not struggling with a budget
deficit problem of the same scale as Spain's, it is only by the grace of
European Central Bank President Mario Draghi and his quantitative
easing program. Italy's debt amounts to 132 percent of its GDP, the
second highest in the European Union after Greece, and its S&P
credit rating hovers just one notch above junk status. In an
unconstrained market, Italy would be paying a much higher interest rate
on this debt, deeply affecting the government's budget, but the European
Central Bank's willingness to buy Italian bonds has caused interest
rates to fall extremely low for the time being. This support will only
work for as long as it is applied, however, and the quantitative easing
program is currently scheduled to end in September 2016. In the
meantime, Italy and neighboring France have shown only meager stirrings
of growth and unemployment loiters above 10 percent in both countries.
In Italy's case, unemployment, 12.7 percent in June, appears to still be
growing. France also suffers from high debt, currently 95 percent of
GDP, and has had run-ins with the European Commission over its high
budget deficit, which stands at 4 percent.
Before
the creation of the eurozone, the French and Italian financial problems
would have had a clear solution. Unlike Germany, which has a deep
intolerance of inflation, France and Italy have regularly used currency
devaluation and inflation to increase competitiveness and reduce debt
levels. Such maneuverings were notably employed during the 30-year
period after World War II, in which the Bretton Woods financial system
and the U.S. implementation of the Marshall Plan coincided to create the
perfect circumstances for growth.
The
prospect of a lasting currency devaluation is now of course complicated
by the fact that both are members of a single currency, and any plan
for engineering high inflation immediately encounters two barriers.
First, the European Central Bank is constructed on a German model and
thus geared primarily toward keeping inflation levels down. Second,
since the members of the eurozone are bound together in a single
currency, the only methods of increasing competitiveness through Germany
are by internal devaluation, as seen in Spain, or by reducing inflation
lower than Germany. However, Germany is unlikely to willingly allow its
own inflation to soar so its eurozone colleagues can inflate away their
debt while maintaining competitiveness. Thus Europe's second and third
largest economies are trapped with low growth, high debt and high
unemployment, and this during a period in which the economic climate is
supposed to be relatively favorable.
Incidentally,
Ireland, another recipient of a bailout with reforms attached, has had
more success in adopting the German model. Its impressive growth has
coincided with an increase in its trade surplus since the crisis struck,
and its exposure to the fast-growing British economy has also helped.
Unfortunately, Ireland's small size (just 1.3 percent of the EU economy)
means that it is unlikely to make a dramatic impact on the overall
picture.
The
German plan, which advocated that Europe's Mediterranean states solve
their economic problems by increasing their competitiveness and thus
transforming to a German model, appears to be failing, or at least
moving too slowly to avert a disaster, such as the loss of confidence in
Italy's ability to pay its debt. The World Economic Forum's Global
Competitiveness Report for 2014 revealed that not one Mediterranean
country is among Europe's top 10 most competitive economies, and they
are mostly stagnant. Comparing their positions to the equivalent 2011
report, France has slipped from 18th to 23rd in the world and Italy from
43rd to 49th. Spain has improved its position but only by one place,
putting it 35th in the world and 16th in Europe.
Thus
talk of a European recovery appears to be premature. Spain, the one
large country that is posting newly impressive growth figures, has not
managed to base this growth on exports, and it still suffers deep
underlying weaknesses, like its counterparts in France and Italy.
Indeed, Spain's recent growth may actually create problems for its peers
if the positivity spreads to the markets and investors begin to move
funds out of bonds and into more growth-friendly instruments. This would
increase government borrowing costs across the Continent irrespective
of quantitative easing, which would be particularly painful for Italy.
Since the financial crisis of 2008, Germany has been repeatedly asked
whether it is willing to subsidize its less competitive neighbors for
the sake of the union. Up until now it has been postponing answering the
question, preferring instead to focus on improving its neighbors'
competitiveness. These attempts appear to be failing, and sooner or
later Germany will face pressure to subsidize its neighbors once more.
And each time the issue comes up, a decision on the matter becomes
harder to avoid.