Markets right to worry about euro zone

October 20, 2014

By Hugo Dixon

Hugo Dixon is Editor-at-Large, Reuters News. The opinions expressed are his own.

The markets are right to worry about the euro zone, the epicentre of last week’s fright. Its three big economies – Germany, France and Italy – are, in their own ways, stuck.

There is, in theory, a grand bargain that might shift the malaise. This would involve deep structural reform by Berlin as well as Paris and Rome; quantitative easing by the European Central Bank to boost inflation; and some loosening of fiscal straitjackets.

But such a deal – hinted at by Mario Draghi, the ECB president, in his Jackson Hole speech in August – is unlikely to materialise soon, if at all.

In the meantime, the region is being battered by shocks from outside and within. The external shocks are: the slowdown of emerging economies, especially China; the row with Russia over Ukraine; the Ebola outbreak; and the war against Islamic State.

As if this were not enough, the euro zone continues to inflict wounds on itself. The latest was Greece’s rush to exit its bailout programme. The bond markets reacted by pushing up Greek bond yields last week to such a level that Athens’ ability to stand on its own two feet is off the agenda for the foreseeable future.

Meanwhile, a snap election may be held in Greece early next year. That would probably be won by the radical left Syriza party, which wants to write off half the government’s debts. This could cause contagion in Italy, whose debts are an eye-popping 137 percent of GDP.

So why doesn’t the euro zone adopt Draghi’s grand bargain? Because the politics is hard.

Italy, to be fair, is reforming its labour market, civil justice system and constitution. But Matteo Renzi, the prime minister, has just published a budget that is light on spending cuts. He is also not doing enough to reduce the government’s debt through privatisation.

France last week published a budget that pushed back a plan to cut its deficit below 3 percent of GDP to 2017. It is not doing enough to liberalise its labour market or cut the size of its welfare state either.

If Rome and Paris were asking for extra fiscal wiggle room to finance investment while cutting current spending, they would deserve support. As it is, their actions could provoke a confrontation with the European Commission on the grounds that they flout euro zone fiscal rules.

What’s more, the Italian and French actions are causing concern in Berlin, where I was last week. German politicians do not like the idea of rules being broken.

Berlin, meanwhile, is digging its own heels in as others try to push it to increase investment spending and reform its economy. The government is fixated on balancing its budget next year. This goes further than a so-called “debt brake” which legally requires close to a balanced budget.

The German people are so convinced that debt is sin that even the SPD, the centre-left party in the grand coalition, is committed to the balanced budget. Sigmar Gabriel, its leader, said last week there were “no economic policy grounds” to abandon the plan when he announced sharply reduced growth forecasts for both this year and next, to 1.2 percent and 1.3 percent respectively.

Germany certainly needs to boost investment, as its infrastructure is decaying. But it is doubtful how much benefit this would bring to other euro zone countries.

It might, therefore, be more productive for Germany’s partners to focus on structural reform – in particular, the need to free up its services markets. Almost every craft and profession is covered by a guild, which specifies long years of training and keeps competition out of the market. The result is that Germany has high quality but expensive services.

If Berlin could be persuaded to open up its markets, this could eventually be an important source of business for other European Union countries. It could also give German consumers a wider range of cheaper services to spend their money on.

The snag is that Berlin doesn’t seem inclined to move on this either, because the guilds are politically well-entrenched. It is happier to lecture other countries about how to restructure their own economies than to listen to suggestions about what to do at home.

That said, it is still worth trying to unblock the impasse. One sliver of hope was an initiative announced this month by Germany’s Gabriel and the French economy minister. They are going to come up with some joint suggestions about how the two economies could reform themselves.

It would be good to see this cooperative spirit on a wider basis. But who is going to be the deal-maker?

Draghi could play a useful role. But his clout in Germany seems to have declined a bit. Both Wolfgang Schaeuble, the finance minister, and Jens Weidmann, the head of the Bundesbank, the central bank, have criticised the ECB for some of its unorthodox policies.

Meanwhile, the European Union is not yet well placed to help given that its leadership is in the process of change. What’s more, Donald Tusk, the incoming European Council president, who coordinates the positions of European leaders, doesn’t seem suited to play the same deal-maker role as the current president Herman Van Rompuy. Tusk doesn’t speak English well and his country, Poland, isn’t in the euro.

That leaves the burden of cutting a difficult deal to Jean-Claude Juncker, who becomes president of the European Commission, the EU’s executive arm, next month. He had better get cracking.

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