Europe is having problems again. This time, the problems have different roots than in 2010 and 2011. For the past two years, investors have feared a contagion of default, triggered by a loss of liquidity and a panic among bankers and other bond investors, something akin to what happened in the United States during the subprime crisis. The European Central Bank’s decision, late last year, to pour liquidity into markets has largely, if not completely, relieved such concerns. The more recent investor fears have attached themselves to the continent’s seemingly single-minded emphasis on fiscal austerity. Because such policies threaten to impose a vicious cycle on weaker nations, one in which budget restraint retards growth, creating still larger deficits that force still more restraint, investors have begun to wonder if these nations can ever reach solvency. The ECB cannot help in this regard. To answer these fears, Europe needs to develop a growth agenda to parallel its otherwise essential austerity measures.
The recession into which Europe already seems to have sunk offers a grim background for such concerns and considerations. Recent reports show unemployment in the eurozone approaching 11% of the workforce, even in the so-called stronger countries of the north. Spain records five million registered unemployed, almost 15% of the country’s working-age population. Industrial production has contracted across the continent, even in the supposedly more vibrant north. Official forecasts call for real gross domestic product to fall more than 4% this year in Greece, 1% in both Italy and Spain, and 3.5% in Portugal. And these figures surely carry the optimistic biases of all official forecasts.
This unattractive picture is partly an unavoidable legacy of past financial problems. Recurrent liquidity crises in 2010 and 2011 undermined the capital adequacy of European banks and bred fear among bankers about the credit quality of other financial institutions as well as borrowers generally. Their consequent caution has rendered Europe’s financial system incapable of fully supporting robust economic activity. The strain shows in all rate spreads, in those paid by sovereign credits, of course, but also in interbank lending and in the rates paid by corporate issuers. Even as the ECB creates large dollops of additional liquidity, the banks’ need to rebuild their capital bases continues to retard lending, force asset sales and generally constrain liquidity. It will for some time to come.
The economic picture no doubt will also suffer from past monetary restraint. Because the ECB, until very recently, has held back from helping in the crisis, it actually compounded the continent’s liquidity problems with monetary restraint. In 2010 and 2011, money circulating in the eurozone grew only slowly, too slowly to support normal economic needs, much less offset the losses brought by the crisis. Europe’s narrow, M1 money measure expanded only 4.3% in 2010 and slowed into the 2% to 3% range last year. Its broader, M2 definition of money expanded at less than a 3% annual rate on average for both years, and the broadest, M3 money measure barely topped that meager growth rate. Even with the ECB’s new, easier policy, it will take months for new money flows to have an economic effect, probably not until the final quarter of the year. In the interim, the legacy of past monetary restraint will dominate the eurozone.
Most constraining of all are the effects of still-tightening fiscal austerity. Led by the Germans, the European Union has insisted on severe spending cuts and tax increases in any nation seeking financial aid. Greece, Ireland, and Portugal have already committed to draconian deficit-reduction schedules. Matters have driven Spain and Italy onto similar paths. Though France, Germany, the Netherlands and other stronger European economies plan nothing so dramatic as the periphery, they have their own, more moderate, deficit-reduction plans. Further, the cutbacks in Europe’s beleaguered periphery as well as slowdowns in China, India, and other emerging economies will constrain export growth in Europe’s stronger economies.
This single-minded emphasis on austerity, though ultimately necessary for Europe to correct its fiscal imbalances, is unfortunate on at least two counts. First, it will contribute to the immediate recessionary forces. Second, it threatens that vicious, self-defeating cycle in which budget restraint slows or halts growth, denying governments revenue, forcing them to spend more on social services and so enlarging deficits, a development that, in turn, forces still more austerity that depresses growth and enlarges deficits still more. In such a world, hope dies that these governments can ever secure budgets that can repay their debts.
Europe could answer such concerns by pursuing a growth strategy in addition to austerity. Such a combination might seem counterintuitive, but, as pointed out by Italian Prime Minister Mario Monti and IMF head Christine Lagarde, opportunities to pursue both strategies simultaneously exist. Even while squeezing their budgets from a macro perspective, the nations on the zone’s periphery—Greece, Ireland, Italy, Portugal and Spain—could, for instance, promote growth by loosening their famously restrictive labor laws. They could propel economic activity by revising their growth-stifling tax codes and by easing regulatory restrictions. Privatization could at once raise funds to retire debt and promise greater efficiencies. A combination of such efforts could overcome much of the immediate, growth-dampening effects of macro spending cuts and tax increases, and also help these economies avoid the vicious cycle that austerity otherwise threatens.
That Europe, as a whole, seems unenthusiastic about such a growth agenda only leaves it that much more vulnerable to the significant recessionary forces already confronting it. The recession will likely go deeper and the budget problems will likely get worse than they otherwise would have. Even so, the United States will feel only a limited impact. Export sales will slow, of course, as will the flow of profits from the very substantial operations many American firms have in Europe. But since the eurozone accounts for only about 12% of U.S. exports (compared, for instance, to over 25% for just Canada and Mexico), the European recession, unless it is much more severe than even the pessimists suggest, is not likely to turn even slow American growth into a recession. Europe’s decline will probably shave only two- to three-tenths of a percent off America’s real growth pace, pushing it to the low side of the 2% to 2½% trend rate established since the 2008-2009 recession.