Europe’s Stagnant Future

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The euro crisis is far from over. The best possible outcome for Europe may be years of stagnation, as the danger of a renewed financial crisis is very real indeed.
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With Italians headed to the polls to elect a new parliament, many Europeans are hoping that the worst of the euro crisis is behind them. But the specter of years of low growth and high unemployment remains.

In a Q&A, Uri Dadush analyzes the euro crisis and what European leaders need to do to fix their divergent competitiveness trends. Dadush argues that the best-case scenario may be years of stagnation as the danger of a renewed political and financial crisis with global implications is still very real indeed.

Is this the beginning of the end of the euro crisis?

No. Unfortunately, the end of the euro crisis is far in the distance. The worst could even lie ahead.

This is primarily a crisis of competitiveness—the eurozone’s periphery has not been able to keep up with Germany, Europe’s economic powerhouse. The fiscal crisis and the banking crisis are in large part reflections of the competitiveness gap, even though other factors are also at play.

Before the euro, it was relatively easy for countries to deal with the divergence of competitiveness, as they could devalue their currency. Naturally, with everyone in the eurozone using the same currency, that is no longer an option. The result is that the periphery is structurally incapable of growing, which has severe budgetary, banking, and employment consequences and is the cause of acute social and political tensions.

While there are positive signs in Ireland, there is a long way to go before the competitiveness problem is fixed. Other economies, particularly Italy, are well behind.

Does the eurozone face an extended period of stagnation?

That is depressingly the best scenario that can be hoped for at this stage.

It is difficult to see sources of growth when many of these countries are uncompetitive. The countries of the periphery are still struggling to borrow money and remain under enormous pressure from the markets to cut back their deficits. Consumption is low and investors are scared.

The only way to reestablish growth is to improve the competitiveness of Europe over time and to reduce the debt burden of the periphery. Both of these things are going to take a long time.

For now, Europe’s crisis is a major drag on global growth. The financial crisis is largely contained within Europe, so it isn’t a disaster for the world, but it could easily explode into a bigger issue.

Will the euro survive?

The odds are that the euro will survive, but this is far from guaranteed. The eurozone could indeed break apart.

If a country did move to exit the eurozone, the trigger would be a political crisis, not one based on a rational economic calculus. The fundamental driver of an eventual breakup would be either a reaction to endless austerity in the periphery or the bubbling-over of resentment in one of the core countries about the amount of money being used to keep the periphery afloat and the share of the burden the core is carrying.

Germany is not likely to make the first move. There are strong political, historic, and economic factor—Germany is the biggest creditor and exporter to the periphery—that make it one of the last countries that will want to pull out.

What countries are most at risk? Is there still the threat of a Grexit?

Greece is obviously the most at risk. The country cannot repay its debt and will require more debt forgiveness. Its government is in a terrible mess. It is the least competitive economy in the eurozone. And it lacks a good export structure that could prop up the country.

Portugal is also in bad shape, and Spain and Italy are in deep trouble. Spain’s economy must undergo an enormous adjustment following the burst of its housing bubble, so, taking that risk into account, investors are probably correctly demanding larger yields on their loans to Spain than to Italy.

But Italy is also in serious danger. Italy’s GDP is down from where it was when the country joined the eurozone in 1999. Though Italy did not experience a housing bubble similar to Spain’s and its unemployment is not as high as other economies, the fact that the economy hasn’t grown in fourteen years coupled with a declining GDP is an indicator that things could go very wrong.

How important is Italy’s election?

The tendency is always to say that every election is crucial. And this is correct in Italy’s case. The same would hold true for any election in Europe’s periphery today because voting points to the significant policy choices that need to be made and creates enormous political tensions—and that’s where the risks ultimately lie.

This election is especially important because Italy is so big. The country is trillions of euros in debt, and it’s one of the world’s largest economies. Unless Italy gets its act together, the euro is doomed and there will be a major financial crisis in Europe that could easily lead to a global financial crisis.

Italy is transitioning away from a technocratic government that made progress on the fiscal balance and on pensions but didn’t do great things to address the structural reforms needed, beginning in the labor market. It did, however, have more success than previous governments in reestablishing the country’s credibility.

The question is how the new leaders will conduct economic reforms. In my view, Italy will end up with a coalition government that has little choice in practice but to persist in the economic policies already under way.

Even if former prime minister Silvio Berlusconi gains the upper hand on Democratic Party leader Pier Luigi Bersani and Prime Minister Mario Monti—an unlikely outcome—the markets will quickly force the new government’s hand. There will surely be differences in tone and style, but reforms will need to continue and there will be little room for maneuver.

Still, this is a very sensitive time. The election matters even if the policies pursued are similar because Italy’s new leaders need to have international credibility in order to reassure the markets.

Have European leaders done enough to avert calamity?

Not at all. When assessing the performance of Europe’s leaders, it’s good to separate the way in which they’ve dealt with the current crisis from what they are doing to build an architecture that assures—to the degree possible—that the euro will survive in the long term.

In terms of fighting the current crisis, politicians across Europe should be doing more. Leaders need to move forward on structural reforms in Greece, Italy, Spain, and other countries at a faster rate. Germany should be doing more to stimulate its own economy.

Building a sustainable architecture is clearly linked to the current crisis because the more progress is made, the more confidence is gained in facing the current conditions. Some of the reforms needed to fix the current crisis, including making labor markets more flexible, can help establish the necessary architecture.

What more needs to be done to establish the architecture needed to protect the euro over the long term and reignite Europe’s economic growth?

For the euro to survive in the long term, the countries of the eurozone need to bolster the EU’s institutional capacity to support member states. They can do so in three main ways.

First, they need to establish a banking union. In the United States, when banks in the state of Florida get into trouble they are not bailed out by the state, they receive federal support. The same is necessary in the eurozone. Some progress has been made on this by adopting a template on common supervision, but European leaders are quite far from making the big reforms that are necessary. This includes a common scheme for insuring deposits and for dealing with banks that fail.

Second, there needs to be greater fiscal unity with a large pool of money at the center. Europe doesn’t need the exact same fiscal structure as the United States, but the center must be more capable of transferring money and intervening when countries and regions are in trouble. Europe has gotten nowhere on this issue. Leaders are responding to this need with as little change as possible and as late as possible because all leaders confront different political pressures.

Third, there needs to be a true lender of last resort in the eurozone. This is where there has been the most movement in the right direction. While the European Central Bank didn’t do enough at the beginning of the crisis, it has assumed a much more positive role since Mario Draghi took over and the inevitability of change became apparent.

But a lender of last resort is not the solution in and of itself. All it does is give states time to take the necessary actions, so the other key reforms cannot be overlooked. The economies in the periphery must carry out structural reforms, and the eurozone countries need to move forward on strengthening the banking and fiscal mechanisms at the center.

End of document

About the International Economics Program

The Carnegie International Economics Program monitors and analyzes short- and long-term trends in the global economy, including macroeconomic developments, trade, commodities, and capital flows, drawing out their policy implications. The current focus of the program is the global financial crisis and its related policy issues. The program also examines the ramifications of the rising weight of developing countries in the global economy among other areas of research.


Comments (4)

  • Peter Wahl
    2 Recommends
    This is a very good summary of the basic mantras in neo-liberal economics - preaching the same old receipts since 30 years, not a single new idea and until today not having understood what has lead us to the crisis.
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  • Paul Ballard
    This note follows the standard Troika analysis. Is that correct ?

    Surely, the immediate cause of the Eurozone crisis - in Greece and other challenged countries - was not an inherent competitiveness problem, but the "external shock" of the global financial melt-down that began in Wall St and metastasized globally? It follows therefore that the number one policy priority was to facilitate a least-cost recovery from this.

    By focusing upon premature drastic fiscal adjustment, without debt rescheduling, the Troika prescription has simply turned a major recession into a depression? This is fundamentally bad macro-economic policy making by the EU - and the main nation-state actors, notably Germany.

    The idea that the prime driver of Greece's crisis was a "competitiveness" problem and not the "external shock" of the global financial melt-down is belied by the fact that, up until the 2008-09 global crash, countries like Greece had found an equilibrium in which they could grow their economies at high rates - if unsustainably.

    The "competitiveness" argument is a very superficial one. It is based upon the notion that a current account deficit at any time equals a lack of competitiveness.

    However, in a single market with a currency union, why should current account deficits of individual states within it be at all significant? After all, isn't the purpose of the monetary union plus single market to enable a larger union of nations to combine and grow collectively without these constraints?

    At the micro-economic level, Greece, for example, has : (1) far lower unit labor costs than Germany - even allowing for a 50% payroll tax; (2) very high quality human capital - based on the UN HD index - higher than the UK and only slightly lower than Germany and France. This suggests that, once labor market rigidities are removed, Greece could indeed be highly competitive.

    A fundamental misdiagnosis of the immediate causes of the Greece crisis has led to a tragic misapplication of "austerity" policies. These have : (a) doubled the national debt since 2009; (b) shrunk the Greek economy by 25%; and (c) increased unemployment from 8% to 27%.

    It is surely the unfounded application of so-called "competitiveness" analysis that has brought this about.

    The best thing the Eurozone and the Troika can do now - urgently - is to enable Greece to reschedule its debt over a long enough time-frame (25-40 years) so that it can fiscally stimulate a turn-around.
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  • mitzi
    For so long a lot of european countries had lived beyond their means, and factor in the us economic crisis we are in deep deep trouble. england has not joined in in the common currency, what is instore for them too?
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    • Paul Ballard replies...
      Hi Mitzi. Good question you raise. However, if you look at the data on pre=2008 crisis Europe, the evidence on "living beyond their means" isn't very strong. Most Eurozone economies actually grew quite strongly - including Greece and Spain. Moreover Ireland was one of the strongest export economies - with very sound macro-economic policies. Absent the Great Recession - that spread from the USA in 2008-09, it is not clear countries like Greece would have suffered the way they have. As for the UK, the current government has aggravated the macro-economic problems and recession it faces by applying the same "austerity" policies that have also failed in the Eurozone, even while remaining outside it. It's also worth recalling that at least half of the UK's exports and economic activity are dependent upon Europe now. By staying outside the Eurozone long-term, I fear the UK is giving up political leverage and the potential for stronger growth.

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