Euro crisis is sleeping, not dead

By Hugo Dixon
July 28, 2014

Euro zone policymakers may feel they can afford to relax this summer. That would be a terrible error. The euro crisis is sleeping, not dead.

The region is suffering from stagnation, low inflation, unemployment and debt. The crisis could easily rear its ugly head because the euro zone is not well placed to withstand a shock.

What’s more, it’s not hard to see from where such a blow could come. Relations with Russia have rapidly deteriorated following the downing of the Malaysia Airlines flight over Ukraine. If Europe imposes sanctions that make Moscow think again, these will hurt it too.

The euro zone needs to take measures to insure itself against disaster: looser monetary policy by the European Central Bank to boost inflation; a new drive for structural reform, especially in France and Italy but also in Germany; and some loosening of budgetary straitjackets.

First, though, look at the problem. Financial markets have been calm for the last two years since Mario Draghi, the ECB’s president, said he would do “whatever it takes” to preserve the euro. But the euro zone is barely growing. The International Monetary Fund last week predicted it would notch up just 1.1 percent growth this year. That’s a pathetic rebound given the recession’s severity.

There are, admittedly, some bright spots. Spain is enjoying a moderate recovery, largely as a result of effectively implementing root-and-branch reform of its labour market and banking system. Even Greece seems to be on the road back from Hades.

But the large economies are not doing well. Italy will grow only 0.3 percent this year, according to the IMF; while France will creep along at 0.7 percent. Germany will do better at 1.9 percent. But even this engine seems to be losing momentum. The Ifo business sentiment index witnessed its third monthly decline in July.

Meanwhile, euro zone inflation is 0.5 percent – well below the ECB’s target of below but close to 2 percent. Such “lowflation” has two bad consequences. It is helping keep the euro strong, which harms the prospects for exporters; and it makes debt burdens harder to bear.

Rome’s debt, which is expected by the European Commission to reach 135 percent of GDP this year, is the most worrying. Unless growth and inflation go up, its borrowings are not sustainable. Given that its debt is 2.1 trillion euros, the repercussions of it getting into trouble would be horrendous. Italy needs to step up its privatisation plans to head off fears that debt could spiral out of control.

Some euro zone politicians, especially from France, seem to think that the solution is to loosen both monetary and fiscal policy. Yes, sort of.

Now that interest rates cannot fall further, the ECB certainly needs to launch a determined programme of quantitative easing. Given the undeveloped state of much of the euro zone’s capital markets, this means buying government bonds in large quantities. There would be two benefits: inflation would go up and the exchange rate would fall.

There is also a strong case for the European Commission to give those countries, which are engaged in serious structural reforms, extra time to hit their deficit targets. Such an approach has worked well with Spain, which was twice given more budgetary leeway during its reform programme. But even when extra time is justified, this should be used to avoid tax rises rather than to let up on cuts in public spending.

What’s more, a programme relying solely on laxer monetary and fiscal policy would be more damaging than helpful. It would take the pressure off governments to reform. A resurgence of the crisis would be probably delayed not prevented. And when it returned, it would do so with a vengeance.

The biggest worry is France. Francois Hollande has done too little to rein in public spending or liberalise labour markets. His newish premier, Manuel Valls, is trying to reform the economy but lacks whole-hearted support from his president, the socialist party and the country. At least Italy knows it has to reform and has a prime minister, Matteo Renzi, who is determined to bring this about.

Hollande now wants to install Pierre Moscovici, his former finance minster, as the Commission’s new economic commissioner. Given the need to keep the pressure on Paris, it would be a mistake to make a poacher one of the gamekeepers.

By contrast, the idea of making Luis De Guindos the new head of the Eurogroup, which brings together the zone’s finance minsters, is a good one. Spain’s finance minister is in a perfect position to explain to his colleagues the value of structural reforms because they have worked so well in his country.

This lesson is something Germany, too, could take to heart. Although Berlin reformed its labour market early in the century, it has since been resting on its laurels. The priority is to free up its services markets. This would have the double benefit of giving more choice to German consumers and opening up its markets to suppliers from other European countries, so boosting their growth.

If governments are prepared to fast-track structural reforms, it is not just the Commission that should be willing to give those that need it extra time to curb their deficits. The ECB should also be happier to launch quantitative easing. Policymakers should use the summer holidays to agree a pact containing these three elements.

No comments so far

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/