The European economy is on a knife-edge

The economic outlook for the Euro Area is more upbeat. This is the message conveyed by business leader surveys. Since the autumn, the situation has clearly improved, suggesting that the economy has at long last exited the long and painful period of recession.
Last week, European Central Bank governor Mario Draghi jumped at this scenario of a more robust economic environment, which ultimately enabled him to maintain the status quo.

One can see clearly the interpretation that can be made of the current environment in the Euro zone and the hopes it can give rise to.
If growth settles on a more solid trajectory then imbalances, which are still present, will gradually fade away. This is another reason why the acceleration in the economic cycle must be encouraged and no longer burdened with a whole set of constraints. In France, the concept of strengthening corporate margins, outlined at François Hollande’s press conference back on 14 January, is attractive as its purpose is to enable companies to lock in and then amplify the business improvement.

The chart clearly shows the change in business leaders’ perception of their environment. The manufacturing sector index is all the more important in that global trade is gathering pace after two long years of very slow progression. The improvement of trade, notably of manufacturing goods, combined with this more positive view of the economic environment could constitute a very positive cocktail for the Euro zone.
There is an urgent necessity to enter this more virtuous circle, as it is the only way of reducing risks related to persistent imbalances.

The first point to be stressed is that for the vast majority of Euro Area countries, per capita income is still lower than its level of 2007. Germany has already exceeded this level but for the euro zone, France, Spain and Italy, this is still far from the case. This configuration, six years on, is a new one. It proves the persistence of the crisis and the difficulties met by the European economy in adapting to a new deal.

Looking at France, the impact of the first oil shock and that of the European Monetary System crisis were not as long-lasting. After a year of downturn, business quickly picked up again. This is not the case today. The return to growth and convergence towards a sustained growth pace will not happen automatically, unlike in the two previous crises. The economy has changed and Europe and France must adapt and alter their behavior.

This situation has an instant fiscal impact. If activity does not pick up, tax revenues will stagnate and the public deficits accumulated during the crisis will not be eliminated. Under these circumstances, public debt is on a trajectory that could prove unsustainable.

For peripheral countries like Spain, Italy and Portugal, these issues are far from settled. France is on the knife’s edge of this fragile situation. If growth does not accelerate on a lasting basis, these countries will be unable to stabilize their public debt. For southern European countries, interest rates are still too high in relation to growth. The former fuels debt and the latter fuels GDP. If, in this way, public debt grows faster than GDP, it will be impossible to stabilize the ratio of public debt relative to GDP, which is the first step in the process. The second step involves setting up a primary budget surplus (fiscal balance without interest payments on public debt) in order to avoid further increasing this debt. This process will only be possible if there is growth. Seeking to get there too quickly, however, would result in a recession similar to that seen in 2011/2012.
Here again, a return to growth is necessary.

The third point to be stressed is that the ECB currently seems to have run out of solutions. Its interest rates are hovering close to 0% and it no longer seems able to provide the liquidity needed to facilitate macroeconomic adjustments. It still cannot buy public debt, unlike its US, UK and Japanese counterparts. It can no longer make direct transactions with banks as when the ECB had implemented this type of measure (LTRO), banks had purchased government bonds. The creation of the Banking Union in 2014 will be an impediment, as one of the reasons for its creation is to separate bank risk from sovereign risk. Mario Draghi had mentioned the possibility of buying securitized credit, but the market is still too narrow. In short, the ECB has come to a dead end as it can no longer play its role as a lender of last resort, the one who takes on the risk that others do not want to shoulder. This situation will only be tenable if growth picks up strongly, so that the ECB no longer has to intervene in support.

The different points outlined suggest that the emphasis must be placed on growth. Traditional regulation methods are no longer working. Budget stimulus is no longer possible and the central bank does not have the same intervention capacity as in the recent past. Different solutions are therefore required. Contingency measures, with a little more of this and a little less of that, no longer suffice.

The Euro Area economies must show themselves capable of locking in and amplifying the recent economic momentum. Economic players probably need more autonomy in order to adjust to the new situation. It is up to each government to help its country’s economy adapt to an environment that has changed spectacularly. Competition, products, technology, economic players, everything has changed and the European economy must adapt to this new environment. Although it does have significant strengths, it must change the way it works so as to regain influence on the global economy, which will not sit back and wait for us.

1 thought on “The European economy is on a knife-edge

  1. Pingback: The Economy in the Euro Area in 2 Charts and a Table | Philippe Waechter's blog

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