Looking Ahead, Europe Faces a Difficult 2013

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Hope springs eternal about Europe's ability to finally resolve its sovereign debt crisis. For despite a double dip economic recession and despite the clearest of signs of austerity fatigue, the markets appear to be buying European policymakers' reassurances that the worst of the crisis is now behind us. The markets do so seeming to have forgotten previous hollow European policymaker reassurances since the start of the crisis in early 2010. They also do so in seeming disregard of the underlying economic and political forces now at play in Europe. Those forces offer little hope that the European periphery will soon extricate itself from its seeming downward economic and political spiral, which could make 2013 yet another challenging year for the Euro.

2012 was not a good year for the European economy. According to the European Central Bank (ECB), the overall European economy again succumbed to economic recession. And it did so before having recovered to its pre-Lehman 2008 crisis peak, which raises the disturbing prospect of a lost European economic decade. Meanwhile the Greek economy literally collapsed, as reflected by a cumulative 20 percent drop in output since 2009, while the economies in Italy, Portugal, and Spain experienced economic contractions of between 1 ½ percent and 3 percent. This dismal economic performance sent unemployment soaring to over 25 percent in Greece and Spain and to over 15 percent in Ireland and Portugal. Worse yet, youth unemployment in Greece and Spain reached over 50 percent.

If 2012 was a bad year for the European economy, it was equally challenging for European political stability. During the year, Greece drifted towards a state of un-governability and large cracks have emerged in its weak three party coalition government, with the extreme left-wing Syriza Party now baying at the gate. At the same time, anti-austerity protests became the order of the day in Portugal and Spain, where strong secessionist pressures also surfaced in Catalonia and the Basque country. Capping these political developments was the recent fall of Mario Monti's government in Italy. That fall could very well mark the end of Italy's year of relative political stability, which Monti's technocratic government brought to the country.

Over the past year, two key policy developments have prevented the Eurozone's deteriorating economic and political fundamentals from driving Europe over the abyss. The first was the bold action taken by Mario Draghi, head of the ECB in response to a market panic that enveloped Italy and Spain in the middle of the year. In response to that panic, Mr. Draghi announced that the ECB would buy unlimited quantities of short-dated Italian and Spanish bonds subject to those countries signing up for economic adjustment programs with the European Stability Mechanism (ESM). The second supportive policy development was a change of heart by German Chancellor Angela Merkel towards Greece. After having insisted earlier that Greece would not receive a third bail-out package, mindful of the German elections scheduled for September 2013, Mrs. Merkel changed her tune and began insisting that Europe was determined to do what it takes to keep Greece in the Euro.

Looking to 2013, there is every prospect that the European economic recession will deepen, and that the economic recovery projected for the second half of 2013 by hopeful European officials will not materialize. After all, the European periphery countries are committed to applying a similarly severe degree of budget austerity in 2013, within a Euro straitjacket that they applied with such dismal results in 2012. And they will now be doing so in the context of an ongoing domestic credit crunch and a very much weaker external economic environment than last year.

The markets are choosing to ignore the likely further deepening in the European economic recession and the consequent further political deterioration in the periphery that seems to be in store for Europe next year. Instead they are pinning their hopes on Mrs. Merkel's resolve to do whatever it takes to hold the Euro together at least until after the September 2013 elections are out of the way. They are also banking on Mario Draghi making good on his commitment to have the ECB buy as many Italian and Spanish bonds as might be necessary to keep interest rates for those countries at reasonable levels.

Sadly, there are all too many ways that the market's present complacency about Europe's economic and political prospects could prove to be ill-founded. A fall in Greece's shaky coalition government would almost certainly result in Greece defaulting on its official loan commitments, which would all too likely set the stage for Greece's exit from the Euro. Similarly a growing anti-austerity backlash and regional problems in Spain could make it very difficult for Mariano Rajoy's government to request ESM financial support, which is a necessary condition for the ECB to buy Spanish government bonds. And then there is always the prospect that a deepening economic recession in Italy and Portugal will heighten political instability in those countries.

One has to hope that the markets are right in betting that Mrs. Merkel will be able to hold Europe together in 2013. However, policymakers in the United States would be ill-advised to base their policies on the assumption that all is going to be well in Europe next year. Since all the signs are pointing to a deepening economic recession and a further deterioration in Europe's political environment that could lead to another intensification of the Euro crisis.


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

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