The Coming Crisis: enduring imbalances in the Eurozone

13 April 2016 

Scott Lavery - SPERI Research Fellow

In the third blog in SPERI’s new series on ‘the coming crisis’ Scott Lavery examines three areas of imbalance in the Eurozone and argues that the single currency area remains vulnerable to a future economic downturn

Jean Monnet – one of the architects of the European integration process – once opined that “Europe will be forged in crises, and will be the sum of the solutions adopted for those crises”.

For the past six years, the Eurozone area has been mired in a protracted economic and social crisis. However, no convincing solution to the euro’s difficulties is yet in sight.

Whilst the policy fixes advanced by European policymakers have thus far averted a break-up of the single currency, they have also consolidated a series of structural imbalances and profound weaknesses within the emergent framework of European capitalism.

These imbalances render the Eurozone particularly vulnerable to a future global downturn.

Three areas of major imbalance stand-out in particular.

First, the Troika’s programme of protracted austerity has produced huge economic and social upheaval. It has been calculated that once fiscal multipliers – the ‘knock-on effects’ of large spending cuts – are taken into account, fiscal consolidation reduced Eurozone GDP by 7.7 per cent in 2013 alone. The effect of this on those countries which were subject to conditionality programmes has been devastating. From 2010 onwards, GDP fell in Greece by 23.5 per cent and investment dropped by a staggering 58.4 per cent. As growth plummeted, Greece’s debt-to-GDP ratio rose substantially, even as it ran primary budget surpluses. In February of this year, Greece slipped back into recession, weighed down by an unrepayable debt burden and unable to stimulate its economy through expansionary measures.

Elsewhere on the Eurozone periphery, trouble bubbles under the surface. Portugal – often held-up as the ‘good pupil’ of Eurozone austerity – has a government debt level of over 129 per cent. A recent IMF report emphasised that a small change in market sentiment could “render Portugal’s capacity to repay [its debts] more vulnerable”. In this context, Portuguese bond yields rose to a two year high in April as investors questioned the durability of the country’s putative economic recovery.

As a result, although growth has returned to some quarters of the Eurozone, it remains in the words of the European Central Bank’s (ECB) president ‘weak, fragile and uneven’. In a context of growing global uncertainty, this renders the Eurozone vulnerable to a future downturn in market sentiment.

Second, the threat of deflation – low and falling prices – continues to haunt the Eurozone’s nascent economic recovery. Over the past three years, inflation has consistently undershot the ECB’s target of 2 per cent. At the start of 2016, headline inflation in the Eurozone stood at minus 0.2 per cent. It looks set to remain at that point throughout the rest of this year.

Photo by Piret Ilver on Unsplash

Deflation represents a major concern for two reasons. First, consistently falling prices can lead households and firms to hold-back on their spending and investment as they anticipate future price drops. In turn, this can lead to lower growth, lower investment and further price cuts: a ‘deflationary spiral’, as was experienced in Japan throughout the 1990s. Second, falling prices increase the value of debt in real terms. This can act as a further disincentive to investment and therefore as a further drag on growth. Unorthodox monetary policy – sustained low and even negative interest rates and Quantitative Easing – has been deployed by the European monetary authorities to counteract this deflation threat. However, these instruments were deployed late and – given the consistent failure of the ECB to hit its inflation target – have proven inadequate.

In the absence of expansionary fiscal policy, the threat of an ongoing low growth, low investment equilibrium looks set to continue, with deflation representing an ongoing threat to the stability of the Eurozone’s economic recovery.

Third, uneven development has intensified between the ‘core’ and ‘periphery’ of the European continent. Amidst years of falling investment, industrial production has collapsed in the Southern European periphery: output has fallen by 25 per cent in Italy, Spain and Greece compared to 2008. This has resulted in a further concentration of industrial activity in Germany, where its share of exports in GDP has increased markedly (up to 50% in 2013), as well as to those economies integrated into its supply chain. German exporters continue to benefit hugely from a real exchange rate which is lower than would have been the case under the Deutschmark. Its financial institutions have also drawn-in huge volumes of capital from investors fleeing turbulence within the Eurozone periphery. The single currency – which was meant to bring about a positive convergence in member states’ economic fundamentals, productive capacity and living standards – has precipitated the precise opposite.

There is no shortage of technical fixes to the Eurozone’s current impasse. Persistently low German unit labour costs – which were stagnant between and 2000 and 2007 and which were a key driver of some of the internal trade imbalances within Europe in the pre-crisis period – continue to be restrained. By reflating demand and allowing some inflation into the German economy, some of these internal imbalances could be corrected. Similarly, the EuroMemo Group of left economists has advanced a series of policy proposals, including plans to launch a European-wide green industrial strategy and to create a Federal-level fiscal policy in order to facilitate redistributive transfers between member states.

These policies could go some way towards resolving the current impasse in Europe. However, in each case the political will to drive through these reforms has been noticeably absent. German exporters and trade union confederations remain resolutely opposed to sacrificing their export advantage whilst Northern politicians – with one eye on their domestic populations – refuse to countenance the possibility of enhanced fiscal redistribution across European borders.

The political impediments to an expansionary rebalancing of the Eurozone are therefore formidable, if not insurmountable. So long as social and political forces capable of articulating an alternative vision within Europe remain marginalised, the imbalances afflicting the Eurozone will most likely persist and even intensify.

In a context of slowing Chinese growth, protracted difficulties in the emerging economies and growing financial market turbulence, the possibility of a second great economic downturn is by no means unthinkable. Indeed, it is looking increasingly likely. If such an event were to unfold, the imbalanced Eurozone is likely to be front and centre of the global maelstrom.

The Coming Crisis SPERI blog series: Next week - Jacqueline Best on current efforts to reinvent monetary policy and the role of central banks. 

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