The immediate causes of recovery are not difficult to discern. Last year, the eurozone was on the verge of a double-dip recession. When it recently fell into technical deflation, the European Central Bank finally pulled the trigger on aggressive easing and launched a combination of quantitative easing (including sovereign-bond purchases) and negative policy rates.
The financial impact was immediate: in anticipation of monetary easing, and after it began, the euro fell sharply, bond yields in the eurozone’s core and periphery fell to very low levels, and stock markets started to rally robustly. This, together with the sharp fall in oil prices, boosted economic growth.
Other factors are helping, too. The ECB’s easing of credit is effectively subsidizing bank lending. The fiscal drag from austerity will be smaller this year, as the European Commission becomes more lenient. And the start of a banking union also helps; following the latest stress tests and asset quality review, banks have greater liquidity and more capital to lend to the private sector.
As a result of these factors, eurozone growth has resumed, and eurozone equities have recently outperformed US equities. The weakening of the euro and the ECB’s aggressive measures may even stop the deflationary pressure later this year.
But a more robust and sustained recovery still faces many challenges. For starters, political risks could derail progress. Greece, one hopes, will remain in the eurozone. But the difficult negotiations between the Syriza-led government and the “troika” (the ECB the European Commission, and the International Monetary Fund) could cause an unintended accident – call it a “Grexident” – if an agreement on funding the country is not reached in the next few weeks.
Moreover, Podemos, a leftist party in the Syriza mold, could come to power in Spain. Populist anti-euro parties of the right and the left are challenging Italian Prime Minister Matteo Renzi. And Marine Le Pen of the far-right National Front is polling well ahead of the 2017 French presidential election.
Slow job creation and income growth may continue to fuel the populist backlash against austerity and reform. Even the ECB estimates that the eurozone unemployment rate will still be 9.9% in 2017 – well above the 7.2% average prior to the global financial crisis seven years ago. And austerity and reform fatigue in the eurozone periphery has been matched by bailout fatigue in the core, boosting support for a range of anti-euro parties in Germany, the Netherlands and Finland.
A second obstacle to sustained recovery is the eurozone’s bad neighborhood. Russia is becoming more assertive and aggressive in Ukraine, the Baltics, and even the Balkans (while sanctions against Russia have hurt many European economies). And the Middle East is burning just next door: the recent terrorist attacks in Paris and Copenhagen, and against foreign tourists in Tunisia, remind Europe that hundreds of homegrown jihadists could return from fighting in Syria, Iraq, or elsewhere and launch further attacks.
Third, while ECB policies keep borrowing costs lower, private and public debt in the periphery countries, as a share of GDP, is high and still rising, because the denominator of the debt ratio – nominal GDP – is barely increasing. Thus, debt sustainability will remain an issue for these economies over the medium term.
Fourth, fiscal policy remains contractionary, because Germany continues to reject a growing chorus of advice that it should undertake a short-term stimulus. Thus, higher German spending will not offset the impact of additional austerity in the periphery or the significant shortfall expected for the three-year, €300 billion ($325 billion) investment plan unveiled by European Commission President Jean-Claude Juncker.
Fifth, structural reforms are still occurring at a snail’s pace, holding back potential growth. And, while structural reforms are necessary, some measures – for example, labor-market liberalization and pension overhauls – may boost the eurozone’s savings rate and thus weaken aggregate demand further (as occurred in Germany following its structural reforms a decade ago).
Finally, Europe’s monetary union remains incomplete. Its long-term viability requires the development over time of a full banking union, fiscal union, economic union, and eventually political union. But the process of further European integration has stalled.
If the eurozone unemployment rate is still too high by the end of 2016, annual inflation remains well below the ECB’s 2% target, and fiscal policies and structural reforms exert a short-term drag on economic growth, the only game in town may be continued quantitative easing. But the ongoing weakness of the euro – fed by such policies – is fueling growth in the eurozone’s current-account surplus.
Indeed, as the euro weakens, the periphery countries’ external accounts have swung from deficit to balance and, increasingly, to surplus. Germany and the eurozone core were already running large surpluses; in the absence of policies to boost domestic demand, those surpluses have simply risen further. Thus, the ECB’s monetary policy will take on an increasingly beggar-thy-neighbor cast, leading to trade and currency tensions with the United States and other trade partners.
To avoid this outcome, Germany needs to adopt policies – fiscal stimulus, higher spending on infrastructure and public investment, and more rapid wage growth – that would boost domestic spending and reduce the country’s external surplus. Unless, and until, Germany moves in this direction, no one should bet the farm on a more robust and sustained eurozone recovery.
Copyright: Project Syndicate, 2015.
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