Maybe, just maybe, the worst of the euro crisis is over. Business and consumer confidence is rising across the Continent, sovereign bond yields are falling, and capital flight from its weakest economies is easing. Talk of an imminent breakup of the currency union has all but disappeared. Even Greece, whose debt hemorrhage plunged the euro zone into crisis three years ago, is starting to meet deficit targets agreed to with its lenders.
“We are now back in a normal situation from a financial viewpoint,” European Central Bank President Mario Draghi said at a Jan. 10 news conference. “We spoke a lot about contagion when things go poorly, but I believe there is a positive contagion when things go well. That’s also what is in play now.” His comments lifted the euro to $1.32, its biggest gain in four months against the dollar.
But the indicators on Europe’s real economy are, if anything, worse than ever. Factory and services output contracted in December for a 17th consecutive month, and unemployment is at 11.8 percent and rising in many countries. The ECB lowered its growth forecast last month and now predicts the euro-zone economy will shrink 0.3 percent this year. “The worst is over, but what we still have to do is difficult,” says Luxembourg Prime Minister Jean-Claude Juncker.
Draghi has done plenty to help financial markets breathe easier. His promise to defend the euro by providing unlimited support to sovereign borrowers reassured investors, thus reining in runaway borrowing costs for countries such as Spain and Italy. He also helped provide financial backstops to troubled banks and pushed through reforms to strengthen European banking supervision.
Draghi is predicting “gradual recovery” in Europe, starting later this year. There’s not much he can do to make it happen, though.
With interest rates already at record lows, the ECB doesn’t have many stimulus tools available. Another rate cut could force the deposit rate, now at zero, into negative territory, which could hurt lending between banks and money-market funds. “The ECB will secretly keep its fingers crossed, hoping that better financial-market conditions and structural reforms eventually really lead to an economic recovery,” says Carsten Brzeski, an economist at ING Group (ING) in Brussels.
This time, leadership will have to come from euro-zone governments rather than the ECB—and the question is whether they’ll have the discipline to keep structural reforms on track. “The pro-reform coalition in Athens is fragile,” economists at London-based Berenberg Bank wrote in a Jan. 11 research note. “Italy needs to stay on the reform track after its elections” next month to replace the caretaker government of Mario Monti. “France still shirks the serious reforms it needs to arrest its long-term decline.”
Even Germany, the region’s economic engine, is showing signs of neglect as labor costs rise and manufacturers fret about losing their competitive edge. “Germany will lose competitiveness if our economic framework remains unchanged,” Anton Börner, president of the German exporters’ association BGA, said at a Jan. 9 press conference.
Joerg Asmussen, an ECB board member appointed by German Chancellor Angela Merkel, said on Jan. 10 that inaction by member governments is now the biggest risk facing the euro zone. The situation “is better than 12 months ago, but this should prompt nobody to weaken reform efforts,” he said.
(With reporting by Simon Kennedy and Jeff Black of Bloomberg News.)