The European Economic and Monetary Union (EMU) is unwell. And with no obvious, fast-acting antidotes, its prospects for the next few years are bleak.
The graph (below) shows the actual GDP growth of the EMU’s four largest economies since the financial crisis alongside that of the UK and the US. It also reveals the European Commission’s forecasts for GDP growth. Unfortunately, average annual growth of 0.2% over an eight-year period compares very badly with the 50-year average of around 3%.
The decline has been going on for longer than 2008, however, and not just in the eurozone. While the term ‘secular stagnation’ has been given a controversial new airing by US economist Larry Summers and others, there is no doubt the eurozone is experiencing a prolonged period of low growth in both aggregate demand and aggregate supply. With trepidation, I offer my case for secular stagnation in Europe.
Globalisation has led to greater equality of incomes and costs between (but not within) advanced and developing economies. This is a double whammy to the competitiveness of richer countries: their exports are still expensive while their imports have become less affordable. Trade suffers as a result.
Contrary to the myths conveyed by eurozone leaders about Anglo-Saxon culpability, many European banks were heavily exposed to the sub-prime bubble
Meanwhile, population growth in the eurozone is falling to a rate below 0.2% per annum and is already negative in Germany and Italy. And after being a significant contributor to growth through greater productivity over the past 20 years or so, the dividends offered by technology appear to have plateaued. Many jobs have been lost for good, however, and the next wave of technological revolution is shaping up to be even more dramatic. Any further productivity benefits may be offset by the redundancies of white-collar workers, as well as blue-collar workers.
Furthermore, governments and businesses are both investing less, if for different reasons. Governments are giving priority to current spending while business investment is held up by uncertain demand and the limited availability of funding.
The damaged banking sector is another concern. Contrary to the myths conveyed by eurozone leaders about Anglo-Saxon culpability, many European banks were heavily exposed to the sub-prime bubble as well as reckless adventures in Greece, Ireland and Eastern Europe. Domestic lending still seems a low priority for many, despite government exhortations and the largesse of the European Central Bank (ECB).
Unaffordable public services are a serious issue in the eurozone. The post-war European welfare state appears to have become an end in itself. This has been a long process, driven by the aspirations of politicians and voters alike. It is now clear that the previous rates of growth in current public spending are unsustainable. So far, Germany has led the way while the bailed-out countries have been obliged to embrace outright austerity. But, to date, France and Italy have been unwilling and unable to do more than merely slow down the rate of the increase in spending.
Finally, consumer confidence has collapsed. Faced with the prospect of job losses, pay freezes, welfare cuts, tax hikes and new and/or higher public service charges, it is no surprise that consumers across most income groups are reining back on their discretionary spending.
So are things going to get better? Unfortunately, this does not look likely any time soon, and certainly not in 2015. And here’s why:
With challenges like these, politicians and central bankers need to face up to secular stagnation and stop pretending that it is ‘merely’ cyclical. It will take time for the required blend of corrective measures to work. Eurozone leaders are unrivalled in their ability to fudge apparently irreconcilable positions, but they will be tested to the full in 2015.
The most commonly cited structural reforms relate to the labour markets, for example, flexibility on hiring and firing, reducing employer costs and enabling training/retraining as job requirements change. The banking sector also needs a lot of attention, but at least the ECB’s asset quality review exposed a lot of the sector’s problems (notably in non-performing assets) even if the associated stress tests were a damp squib. Restrictive professional practices that affect professions ranging from lawyers to pharmacists to taxi drivers are another major barrier to growth. Then there are shop opening hours, complex tax codes and even the red tape involved in setting up a new business. The list is long, the obstacles large and the hard work has barely started.
It is important to remember that the ECB was not designed to deal with stagnation, but rather to enforce German rectitude on inflation. ECB president Mario Draghi now seems to be seeking a shoot-out with the Bundesbank and the German government, but it may not just be about purchasing sovereign bonds. It is far from clear that quantitative easing (QE) would achieve much, since its main benefit appears to be providing liquidity to prevent meltdown in financial markets and Europe is currently awash with liquidity. It is, moreover, questionable whether new cash from QE would rapidly flow into lending by banks and spending by consumers or investment by business.
It is understandable that the French and Italian governments are refusing to toe the line on 3% annual budget deficits. They face powerful unions and wider voter opposition. Meanwhile, the direct and indirect cost of strikes and social upheaval could be severe. Moreover, investors have an almost infinite appetite for sovereign debt, albeit they might expect higher yields. The key is to win popular support for national budgets that restrict current spending in favour of investment.
A unilateral exit could be costly, involving capital controls and unfavourable rates for legacy debts without boosting exports. An orderly break-up would also be disruptive, but still preferable if the Germans and French cannot agree on a common fiscal approach, including eurobonds and other transfers. The Germans may also find it legally, as well as politically, impossible to support further monetary easing.
Representing 18% of world output, the eurozone remains (just) the planet’s largest trading block. Its travails affect us all and schadenfreude seems especially malapropos. No guesses needed, therefore, for whom the bell tolls.
Alastair Winter is chief economist at Daniel Stewart & Co
