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.

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