Will the European economy’s summer squalls turn into an autumn tempest?
Following the grim market response to European Central Bank President Mario Draghi’s latest monetary policy pronouncements, Europe is approaching another make-or-break moment comparable to the crisis of 2012. The summer quarter ended this week, and financial markets delivered their judgment on just how bad things are, pushing the euro down to its lowest level since September 2012. Europe’s quarterly stock market performance was the worst since the nadir of the euro crisis. The question is whether the miserable summer will give way to a milder autumn. Or whether the summer squalls will turn into a catastrophic tempest.
Given the absence of any decisive action at this week’s European Central Bank meeting, the answer will depend on three events in the month ahead: the Ukrainian elections on Oct. 26; the bank stress tests due to be finalized in late October by the central bank, and the judgment on French and Italian budget plans due to be delivered in outline by Europe’s political leaders at the Milan “growth summit” on Oct. 8 and then in detail by the European Commission at the end of the month.
To understand the significance of these events for the European economy and financial markets we must consider the causes of Europe’s summer slump. Not just the general lack of competitiveness or dynamism often blamed for Europe’s economic problems — but the specific things that went wrong since early May, when the euro peaked at 10 percent above its current dollar level and the ratio between euro zone and U.S. stock markets was 18 percent higher than it is today.
The abrupt slump has three plausible explanations. First, disappointment about the timidity of monetary action, as confirmed by the market response to this week’s European Central Bank meeting. Though the ECB in early June announced negative interest rates and other plans to ease the credit crunch in southern Europe, it soon became apparent that banks in the region would continue to reduce their lending. At least partly because they lacked the capital to support more loans.
Second, German politicians spent much of the summer ratcheting up pressure on the French and Italian governments to abandon planned tax cuts, which threatened to push their deficits beyond euro zone budget targets.
Finally, the war in Ukraine, which seemed to subside after Russia’s annexation of Crimea in mid-March, took a sharp turn for the worse after Ukraine’s presidential election in May and the downing of the Malaysian airliner on July 17. The conflict and the sanctions against Russia caused a collapse in consumer confidence and business investment in the euro zone’s one strong economy, Germany.
Starting with Ukraine, the ceasefire is holding for reasons I described here two weeks ago. Better still, the apparent split between Ukraine’s pragmatic President Petro Poroshenko and his more belligerent prime minister, Arsenyi Yatsenyuk, looks increasingly like pre-election political posturing rather than an indicator of fundamental unwillingness to do a deal with Russia after Oct. 26. If so, fears of an escalating war in Ukraine will soon cease to be an influence on economic conditions in Germany and the rest of the European Union.
The outlook for European fiscal policy should also improve in the coming weeks. Next week’s growth summit in Milan was convened by Matteo Renzi, the Italian prime minister, with the specific intention of persuading German Chancellor Angela Merkel to agree to some fiscal stimulus at the pan-European level, in addition to tax cuts in France and Italy. Perhaps in exchange for promises of more intensive structural reforms. Even if Merkel refuses openly to endorse an easing of fiscal austerity, a more flexible interpretation of the EU fiscal rules is likely after the appointment of Pierre Moscovici, the former French finance minister, as the EU commissioner responsible for budgetary enforcement.
Third, and perhaps most important, the ECB stress tests could transform credit conditions in southern Europe. The central bank’s main instruments for stimulating economic growth in Europe are securities purchases and “targeted long-term refinancing operations,” designed to stimulate corporate credit.
But these policies only work if banks have enough capital to be able to expand their loan books. Which is why the stress tests are so important. Their stated purpose is to establish beyond doubt that all major European banks are adequately capitalized. Not only to support their present loan books, but also to support future credit growth.
If the ECB could persuade financial markets that major banks are either already adequately capitalized or have credible plans to raise capital for what will genuinely be the last time in the current business cycle, finding investors to provide that extra capital should not be a problem. Once banks are adequately capitalized, the ultra-cheap money provided by the central bank through its refinancing operations and securities purchases would have a genuine chance of relieving the credit crunch, especially in Italy and Spain.
The combination of easing credit conditions in southern Europe, moderate tax cuts in Italy and France and reduced military confrontation in Eastern Europe would seem to provide a good foundation for a revival of economic growth in early 2015.
But now for the bad news. In the past few days, all three components of this recovery story have been thrown into doubt. Despite the Ukrainian ceasefire, Western governments have suggested that the Russian sanctions will be maintained indefinitely, thereby damaging one of the strongest markets for German exports and removing any incentive for President Vladimir Putin to compromise with a new Ukrainian government.
Last week, ECB officials warned that market expectations that the stress tests would produce a major capital restructuring of the EU banking system were “probably exaggerated.” This week, the European Commission indicated that, far from increasing budget flexibility, it might actually tighten the interpretation of budget rules.
These stories may all turn out to be false because policymakers often try to lower market expectations ahead of major moves. But if European governments really tighten austerity instead of relaxing it, if banks fail to recapitalize and if relations with Russia deteriorate instead of improving, then Europe’s miserable summer will turn into a long, dark winter.
PHOTO (TOP): Mario Draghi, president of the European Central Bank, answers reporter’s questions during his monthly news conference at the bank headquarters in Frankfurt, December 5, 2013. REUTERS/Kai Pfaffenbach
PHOTO (INSERT): Ukrainian President Petro Poroshenko speaks to the media during a news conference in Kiev, September 25, 2014. REUTERS/Valentyn Ogirenko