Calm Before The Gathering Storm In Europe

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Despite the present calm in European financial markets, all is far from well in the Eurozone's political economy. Yet, true to form, European policymakers are showing no sign of taking advantage of this calm to adopt those measures that might place the Euro on a surer footing for the day when global financial conditions are no longer as favorable as they are right now. This failure to act has to be regretted since it makes it all too likely that, in the year ahead, Europe will continue to constitute the primary risk to the global economic recovery.

Among the clearer indications of Europe's present economic malaise is the very depressed level of economic activity in its economic periphery. This remains the case despite the tentative signs of an incipient overall European economic recovery. Beyond the literal collapse of the Greek economy, where economic output has now contracted by around 25 percent since the onset of the crisis, economic activity in major European economies like Italy and Spain is now some 7 percent below its 2008 peak. Worse yet, unemployment in Europe as a whole remains stuck at over 12 percent while in countries like Greece and Spain overall unemployment is now still well in excess of 25 percent of the labor force.

Further indications of the European periphery's economic vulnerability to an eventual tightening in global liquidity conditions are the unsustainably high level of its public debt and its continued lack of international competitiveness. Leaving aside Greece, where public debt now exceeds 175 percent of GDP, public debt levels in Ireland, Italy, and Portugal are now all in excess of 125 percent of GDP and are yet to show any sign of stabilizing. At the same time, while Ireland has succeeded in regaining international competitiveness, countries like Italy, Portugal, and Spain are characterized by continued very weak international competitiveness positions.

As troubling as Europe's economic vulnerability, has been the steady erosion of political support for centrist governments across the European periphery. Years of rising unemployment and of demands by their European partners for painful budget austerity and structural reform have seen a major increase in support for populist parties in the European periphery. This has to raise questions about those countries' political willingness to stay the course of budget adjustment and structural reform. At the same time that austerity fatigue has been taking hold in the periphery, popular opposition to bailout packages has been on the rise in Germany, Austria, and the Netherlands. This is bound to complicate the putting together of future bailout packages as might be needed.

There is broad consensus among European policymakers that a resolution of Europe's economic and political crisis requires an early restoration of meaningful economic growth in the periphery. For without economic growth it is difficult to see how countries in the periphery can possibly service their large mountain of public debt. And without economic growth that might make a significant dent in Europe's presently high unemployment level, it is difficult to see how a political consensus can be maintained for persevering with the budget austerity and structural economic reform measures that are still needed to address the periphery's still very large economic imbalances.

Sadly, while European policymakers might agree that more rapid economic growth is of the essence for an early resolution of the Eurozone's debt crisis, they show little sign of taking decisive policy action to promote that growth. This is particularly evident in their lack of action to address the ongoing European credit crunch, which continues to afflict the European periphery and which continues to constitute a major drag on economic activity. In particular, European policymakers, particularly in Germany, continue to drag their feet on quickly moving towards a European banking union that might help to put Europe's troubled banking system on a securer footing.

A recent study by the Institute for International Finance underlined the gravity of the European credit crunch. It showed that, over the past few years, banks had almost halved their credit to small and medium-sized enterprises in the European periphery. It also revealed that those companies in the periphery that could raise credit had to pay interest rates that were approximately double the rates paid by companies in the European core. This makes it difficult to see how, in the absence of a solution to its bank credit problem, the European periphery can return to meaningful economic growth especially at a time that it is being forced to continue pursuing budget austerity policies.

Over the past few years, an unfortunate but well established pattern of European policymaking has been that real change is only undertaken in the midst of a crisis. One must hope that this pattern will soon change. For judging by the populist political winds of change now blowing in Europe, time would appear to be running out for sticking with policies that do not produce economic growth.

Desmond Lachman is a resident fellow at the American Enterprise Institute. 

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