Financial conditions in Europe are improving, and the sense of imminent doom has lifted. Some commentators are daring to say that Europe’s economic crisis is over. We think they speak too soon.
It’s true that some crucial indicators look better. Governments that were on the brink of bankruptcy last summer have seen bond yields fall to supportable levels. Six months ago, Spanish 10-year bonds paid more than 7 percent; today the rate is 5.2 percent. Italy’s 10-year borrowing cost has fallen from 6.5 percent to 4.3 percent. And this week, Italy sold €8.5 billion ($11.5 billion) of six-month bills at 0.731 percent, the lowest rate in almost three years.
Unfortunately, what confidence can give, lack of confidence can just as suddenly take away—and that’s especially true if the underlying issues haven’t been resolved. In Europe, they haven’t. In some ways, conditions are getting worse.
The International Monetary Fund’s economic forecasters have marked down Europe’s prospects yet again. They expect the euro area’s output to shrink 0.2 percent this year (a reduction of 0.3 percentage points since the previous forecast) and to recover very slowly in 2014.
Output is expected to shrink 1.5 percent in Spain (where unemployment stands at more than 25 percent) and 1 percent in Italy (where the jobless rate is almost 11 percent). Prospects that dire call into question Europe’s political stability, and that puts recovery in doubt.
Because of the single currency, there isn’t a lot that monetary policy can do to lift the region’s struggling economies. Fiscal policy continues to widen rather than narrow intra-European disparities. The region’s weak economies, under pressure to improve their finances, are trying hard to curb public spending and raise revenue, which adds to the contraction.
The weaklings’ banks are under greater-than-average stress as well—early repayment of European Central Bank loans notwithstanding—so their households and companies struggle to get credit.
European Union leaders should attend to unfinished business. Even now, fiscal transfers from strong economies to weak ones would help soften the economic cycle and lessen the shocking disparities in output and employment across the region. More flexible labor markets are also vital. And the just-proposed banking union, combined with better regulation, would strengthen financial markets and help make the recent improvement in confidence more durable.
In these and other areas, however, Europe’s governments continue to dither. The easing of crisis conditions has a downside: It accommodates their tendency to act only when forced to. Last summer’s moves by the ECB, including the relaunching of the euro—as its president, Mario Draghi, said last week—gave Europe’s leaders breathing space. They would be fools to waste it.