The end of the eurozone’s long recession has been met with relief by its policy-makers, with some jumping on the news to justify their management of the eurozone crisis. They argue that the eurozone economy is on the mend, and the recovery will gain momentum over the coming quarter. If they are right, then the outlook for the euro has indeed improved : faster growth will make it easier for countries to service their debt, bring down unemployment and help contain political populism. Unfortunately, their optimism is almost certainly misplaced. The basic problem is that the world cannot accommodate a Europe refashioned in Germany’s image.
Economists should always be wary of extrapolating from a period of exceptionally bad economic performance. Economies do recover, as the sudden jump in the UK’s growth rate over the course of 2013 shows. But there are reasons to doubt that the eurozone’s return to growth in the second quarter of 2013 (ending six consecutive quarters of contraction) is the start of an economic rebound strong enough to get on top of debt ratios and bring down unemployment.
First, so far the recovery is not worthy of the name. The eurozone expanded by just 0.3 per cent, and will have grown at best by a similar amount in the third quarter. At that pace it will take two and a half years for the eurozone to regain its pre-crisis size.
Second, the return to growth hardly vindicates the eurozone’s austerity strategy ; growth in the second quarter was boosted by an easing of fiscal austerity. Investment did pick up marginally, bringing to a close eight consecutive quarterly declines. However, investment was still down almost 4 per cent compared with the previous year. Private consumption, meanwhile, was lower in the second quarter of 2013 than the first. The biggest contribution to growth came from net exports (growth of exports outpaced that of imports).
This is not the basis of a sustainable recovery. It is highly unlikely that fiscal policy will continue to make a positive contribution to growth beyond the third quarter of 2013. Many eurozone economies are falling behind on their deficit reduction targets, and will therefore come under pressure to tighten policy. Germany has indicated that it has no intention of imparting any fiscal stimulus, despite running a budget surplus and the German economy barely expanding (the Deutsches Institute für Wirtschaftsforschung, for example, expects growth of just 0.2 per cent in the third quarter). Fiscal policy may not act as a major drag on economic activity across the eurozone over the next few years but neither will it be a source of economic growth.
Net exports have kept the eurozone economy afloat. Between the trough of the crisis in the second quarter of 2009 and the second quarter of 2013, the eurozone economy expanded by 3 per cent. Over this period domestic demand fell by 0.7 per cent. Put another way, all the growth the eurozone enjoyed was dependent on demand generated outside of the currency union ; without it the eurozone would have continued to shrink.
The result has been a big swing in the eurozone’s current account position. In 2008 the eurozone had a deficit of around €85 billion (less than 1 per cent of GDP) ; it is on course to have a surplus of close to 2.5 per cent of GDP in 2013. Eurozone policy-makers cite this shift as evidence of improved competitiveness. The truth is simpler : falling eurozone domestic demand hit demand for imports, whereas rising demand around the world boosted demand for eurozone exports.
It is a moot point whether the external surplus can continue rising. Leaving aside the fact that the eurozone is flouting its G20 commitments to prevent the growth of large trade imbalances, it is probably already hitting the limits of the possible. The eurozone is simply too big an economy for the rest the world to keep it afloat. A surplus of 2.5 per cent of eurozone GDP already comprises a big drag on the global economy, which the eurozone in turn is increasingly dependent upon.
Much of the growth in eurozone exports over the last ten years has come from emerging markets. For example, between 2002 and 2012 eurozone exports to China rose fourfold. But that growth has now slowed rapidly – over the first six months of 2013 exports to China were less than 1 per cent higher than a year earlier. It is a similar story with exports to Latin America and Central and Eastern Europe. The share of the eurozone’s total exports accounted for by the US and UK has fallen to less than a quarter, so modest economic recoveries in those two countries will not boost eurozone exports that much.
Nor will it be easy for eurozone economies to boost net exports by increasing their shares of global markets (or even maintain their shares of growing global trade volumes). Germany managed this from 2002 onwards, building up a huge external surplus in the process. But Germany had an undervalued real exchange rate – both relative to other members of the eurozone and relative to the rest of the world (because of the weakness of the euro). The euro remained weak because Germany’s surplus was offset by the deficits of the other member-states. That is now changing as all eurozone economies have current account surpluses or are close to having them. An economy with a big trade surplus tends to experience currency appreciation, because demand for its currency outstrips the supply of it. Eurozone policy-makers bemoan the strength of the euro, but it is a product of their strategy. A strong euro will hit demand for eurozone exports, especially the more price sensitive ones of the southern European member-states.
Rising exports are not going to trigger a substantial recovery in investment demand and hence employment and consumption. True, some rebound in investment is inevitable. Economic recoveries tend to be driven by investment because it falls by more than any other component of GDP in a recession. The eurozone is no exception : investment is down around 20 per cent relative to the pre-crisis period. Machinery and equipment will wear out and need to be replaced. Some firms will get round to making the investment which they had put on ice. But there is little chance of spending returning to pre-crisis levels in the foreseeable future for a number of reasons.
First, a big recovery in investment across the eurozone requires debt relief for the struggling member-states. Relief will happen but it will inevitably be drawn out. The strategy towards Greece gives a good indication of how the issue is likely to be managed. Policy-makers will eschew the big write-offs that could kick-start a recovery in confidence, preferring instead to lengthen pay-back periods. One reason for this is that much of the debt is now held by public institutions ; it is much harder to write-off debt when it is tax-payers rather than private investors who face losses.
Second, the weakness of bank balance sheets means that credit is expensive and scarce ; eurozone bank loans were down almost 4 per cent in August compared to a year earlier, and by much more in the hardest-hit economies. Banks will remain undercapitalised and confidence in them weak due to the likely failure to put in place a sufficient pan-eurozone fiscal backstop.
Moreover, even if the eurozone were to move aggressively to reduce the debts of the struggling member-states and to recapitalise their banks, investment is unlikely to rebound to pre-crisis levels, because some of the investment in the south and elsewhere was unsustainable. For investment to return to pre-crisis levels over the eurozone as a whole, it must rise in Germany. But there is no indication of this happening. In the second quarter of 2013, German investment was still 5 per cent lower than five years ago, and lower as a proportion of GDP than 10 years ago.
A rebound in private consumption requires a mixture of lower unemployment, rising real wages and a fall in the proportion of household income saved. In light of the weakness of investment, it is hardly surprising that unemployment remains high across the eurozone as a whole. Against a backdrop of exceptionally weak domestic demand, the bargaining power of labour is feeble and real incomes are under pressure ; small gains in Germany are being more than offset by falls elsewhere in the currency union. Wage restraint could price people back into work, as it did in Germany. But if Germany is anything to go by, that will have little impact on consumption or investment. Private consumption fell from 59 per cent of German GDP in 2002 to 56 per cent in 2012. It is now growing but not by enough to raise its proportion of GDP. With the language of austerity still dominating politics, and public services being cut in most eurozone economies, it is hardly surprising that households are reluctant to spend money.
Implicitly or explicitly, Germany is the benchmark for the eurozone. Its experience should worry advocates of the current strategy. German policy-makers like to argue that domestic demand is now contributing as much to economic growth as net exports. But net exports are still positive, which means the country is becoming more, not less, dependent on foreign demand. And although domestic demand is expanding, it is doing so at an anaemic pace. Unlike Germany, the eurozone will not be able to rely on an undervalued currency and net exports to boost economic growth.
The eurozone needs policies suited to a large continental economy which cannot rely on exports for economic growth. First, countries with large trade surpluses should not be allowed to tighten fiscal policy ; instead they should be trying to boost demand and rebalance their economies. The European Commission should be as concerned about excessively low wage growth and large structural trade surpluses as it is about excessive rapid wage growth and trade deficits. Second, the institutional fault lines cannot be fudged indefinitely. The eurozone does not need to become the United States of Europe, with a large federal budget and fiscal transfers of the kind present within existing member-states of the EU. This would be politically impossible and of uncertain economic merit. But it does need a functioning banking system. And member-states’ debt burdens have to be reduced to a level which are consistent with a return to sustained economic growth. The end of the eurozone’s recession may do more harm than good if it emboldens policy-makers to persevere with the current strategy.
