The European Commission published its latest estimates for eurozone growth on Monday. A few positive economic signals prompted a slight upward revision of the forecasted growth for 2014 — from 1.1 to 1.2 per cent. With three consecutive quarters of positive growth, the European economy is pulling out of the slump, mostly thanks to the end of the sovereign debt crisis. The European Central Bank (ECB) radically changed its stance between July and September 2012, providing de facto insurance to the peripheral eurozone countries that were in trouble. For the market-determined risk premiums on government bonds, it was enough that the ECB finally agreed to play the role of lender of last resort. Overall low rates and turmoil in emerging countries completed the job, channelling investor resources towards eurozone peripheral countries. The impact of lower long-term market rates has been partly reflected in bank interest rates, and credit supply conditions are generally less restrictive today than they were between early 2012 and mid-2013.
These positive signs are being heralded by governments and moderate parties in the run-up to the European parliament elections on May 25 in an attempt to undercut eurosceptic political parties. But the recovery remains fragile, and the risk of a deflationary spiral is not remote. There are, in fact, numerous reasons to remain worried.
First, current growth rates are barely enough to avoid further increases in unemployment. The eurozone’s seasonally adjusted unemployment rate was 11.8 per cent in March. This has been roughly stable since December 2013. A serious reduction in unemployment — there are still almost nine million unemployed people — would require substantially higher growth rates than the ones projected for the next few years. Without at least 2.5 per cent overall GDP growth, unemployment will remain at around the current levels.
High unemployment heightens the risk of a deflationary spiral. While the current low inflation rate is partly due to changes in energy prices, the fact remains that core inflation has been under 1 per cent for the past few months. Under these conditions, a plummeting of inflationary expectations cannot be ruled out, which would undoubtedly push the eurozone into a deflationary spiral. The ECB has been concerned about this for several months and claims that it is ready to act. However, no concrete proposal to ease monetary policy and ensure that expectations are not anchored to a deflationary trajectory has been put forward. Persistently high unemployment is holding back wage growth, and purchasing power remains depressed, thus contributing to the deflationary spiral.
Fiscal policy is also responsible for the deflationary pressures. While it is true that the harsh austerity imposed on the peripheral countries has somewhat softened, large countries like France and Italy are persisting with their fiscal consolidation efforts. This has a negative impact on demand, for the eurozone as a whole. Even Germany, which is virtually at full employment, is stuck in a broadly restrictive stance, in spite of the presence of the social democrats in the ruling coalition.
The situation in the eurozone is reminiscent of Japan in the 2000s. The country began to experience deflation in 1999, following the recession associated with the Asian crisis. At the time, despite an average growth rate of 1.4 per cent between 2000 and 2006, prices failed to pick up. Despite pursuing expansionary monetary policies, the Japanese central bank could not find a way out of the trap. This is precisely the predicament the eurozone finds itself in today.
But while the sluggish recovery is a major cause for concern, there is something more important to worry about. The crisis has, in fact, exacerbated the divergence between European countries. While overall unemployment is high, it is dramatically so in some peripheral countries, like Greece (26.7 per cent in January 2014) and Spain (25.3 per cent). In these countries, investment is at an all-time low. In Greece for example, investment is just 35 per cent of what it was in 2007, and austerity has seriously affected the quality of education and healthcare. The result is that both physical and human capital have been destroyed, and the capacity of these countries to benefit from the recovery is seriously hampered. This vicious dynamic is captured by the World Economic Forum competitiveness index. Compared to the mid-1970s, core countries like Germany and Finland have improved their ranking, while peripheral countries have all become dramatically less competitive. The proponents of austerity had claimed that it was a bitter pill, necessary to emerge from the crisis as a more cohesive, competitive and dynamic eurozone. But they have been proved wrong. Today, the eurozone is even more heterogeneous and, hence, fragile to external shocks, than it was in 2007, at the outset of the crisis.
It is hard to believe that the current macroeconomic trends, and the self-congratulatory attitude of the European elites, will alter this bleak picture. The projected breakthrough of eurosceptic parties into the European parliament is, therefore, no surprise. A radical change in policies, and in politics, is needed.
The writer teaches economics at Sciences Po, Paris and at the Jakarta School of Public Policy. He co-edited ‘Reforming Europe’, a volume exploring solutions to the current European crisis. Twitter: @fsaraceno