Good news from the Eurozone … or is it?

The ECB’s decision to consider purchasing government bonds led to relief in many troubled Eurozone economies. AAP

Finally good news from the Eurozone! According to recent Eurostat estimates the combined economy of this troubled region grew by 0.3% in the second quarter of 2013 after shrinking for six subsequent quarters in a row. But closer inspections show that the region is still facing deep problems. A sustainable improvement depends crucially on the political ability of policy makers to implement bold institutional reforms and revive the region fast.

Has the Eurozone overcome the recession?

In technical terms the answer is yes (recessions are commonly defined as two subsequent quarters of shrinking GDP). However in economic terms, the Eurozone economy is weaker than ever since the start of the crisis.

If we look at the annualised performance rather than just at the last quarter, the same data source reports a still shrinking Eurozone economy (0.7%). Moreover, actual production is still far below its potential. IMF estimates see the output gap peaking in 2013 at 3%. No wonder the Eurozone unemployment rate is currently at an all time high of 12.1%.

Furthermore, the performance is very uneven. Germany and (surprisingly) France show the strongest signs of recovery with Q2 growth rates of 0.7% and 0.5%, respectively. Even more surprising is the strong economic development of Portugal (1.1%), after shrinking by 2% in the past year. However, the country is still suffering from a peaking output gap of 5.1%. Other problem economies, including large countries like Italy and Spain, and important ones like the Netherlands, are still in recession technically and economically.

In sum, the Eurozone seems to have reached the bottom for the time being. Some “green shoots” are becoming visible. But for the region as a whole, as well as for many of its most troubled members, it is still a very long road back to normality.

Where are the “green shoots” coming from?

Proponents of front-loaded austerity suggest that structural reforms in problem countries are the core factor behind recovery. To be sure, deep recessions that last long enough can help to bring wages and prices down to restore the external competitiveness problem by means of an “internal devaluation”. Nevertheless, wages and prices have proven in many cases to be downward rigid – more so in Spain, less so in Greece where the crisis was much more severe. And it takes a long time to reap the fruits of structural reforms.

All of this may have helped a bit, but there were several other factors that had a much greater impact.

First, one cannot underestimate the role of the European Central Bank (ECB). Its decision in August “to do what it takes to rescue the Euro” by considering (conditional) purchases of government bonds within countries in trouble, has stabilised the situation. Interest rate spreads for these countries went down drastically and provided much relief. As expected, the ECB did not actually have to undertake such “outright monetary transactions” (OMT) to achieve this result. No government bonds have been bought under the program so far!

Second, the strict austerity policy stance has been somewhat relaxed recently. Important factors contributing to this remarkable change are the problems of France to meet the requirements of the fiscal criteria, and the upcoming general elections in Germany. Germany was facing a drop in quarterly GDP in early 2013 and was thus in dire need of a recovery in the Eurozone, the major customer of its export-oriented economy. Remarkably, this change in the policy attitude of Angela Merkel went largely unnoticed in the German public, which still views Chancellor Merkel as the herald of austerity.

Third, Germany itself has adopted a light expansionary policy in the run-up to its own elections. The IMF has recently welcomed “the modest loosening of fiscal policy to help generate growth in domestic demand”. Moreover, German wages in the private and public sector have increased in 2013 by more than 3% helping to stabilise not only growth via private consumption, but also realigning prices and wages throughout the Eurozone by slightly inflating the German economy.

Finally, the institutional reform is making progress with the European Stability Mechanism (ESM) now in place and a banking union in the making. Even though the implementation processes are taking place painfully slowly, their promises for more stability in the future have been very helpful in restoring confidence.

Is the Eurozone crisis over?

The answer is clearly no! Everything depends on the determination of policy makers to go ahead with effective anti-crisis policy measures addressing serious downside risks:

• The OMT program of the ECB is essential for stabilising both troubled national economies and the Eurozone as a whole. Yet, the German constitutional court is expected to rule shortly on whether this program is in line with the German constitution.

• The debt-to-GDP levels of the whole Eurozone and most countries are higher than ever before. More than two years of austerity policy have not solved the problem, but rather intensified it.

• Further debt restructurings for the most seriously affected countries, such as Greece, are still feared. This poses the challenge of containing potential contagion effects – again.

• High unemployment, especially youth unemployment, in problem countries threatens the social fabric of these countries and their willingness to pay the high price for staying in the Eurozone.

• In core countries like the Netherlands, the ongoing recession has nurtured anti-Euro feelings. For the first time in Germany, an explicit anti-Euro party participates in the general election next month, threatening Angela Merkel’s current coalition government.

What is needed?

First, rapid progress towards a renewed institutional structure of the Eurozone is needed to provide stability. This requires a strong central bank as a lender of last resort, preparation for eventual debt monetisation, a true banking union, a cleaning-up of bank balance sheets, and a fiscal compact that is flexible enough to avoid deepen-the-recession austerity measures and strong enough to enforce fiscal consolidation in good times.

Second, stability alone does not ensure growth and prosperity. Reviving growth and employment, especially youth employment, is essential to avoid long-lasting (hysteresis) effects of over-restrictive front-loaded austerity policies that can slow or prevent growth for a very long time.

The Eurozone still needs bold policy measures in both areas to really take advantage of the first “green shoots”. And it needs policy makers who have the courage to implement these policies. Alternatively, a long period of economic stagnation (remember Japan after the banking crisis in the 1990s) with a high risk of political disintegration continues to threaten the Eurozone, and eventually the whole European project.