Europe’s economic prospects are picking up, according to the European Commission. Growth is slowly gaining momentum, say the forecasters in Brussels, and “the conditions for sustained recovery in the medium term are also improving.” In a Bloomberg Markets poll, 83 percent of investors say they believe the euro area’s economies are either stable or getting stronger. The crisis appears to be over. Supposing that’s all true, is it really good news?
The answer isn’t obvious. Granted, sluggish growth is better than no growth. Output this year is expected to be just 1.2 percent higher than in 2013, but after a prolonged contraction, any recovery is welcome. It’s encouraging, too, that the EU has avoided the most frightening meltdown scenarios. In 2011, when the crisis was at its worst, many dreaded an outright collapse of the euro currency system. That would have been a calamity, causing an even worse recession. Thank heaven it didn’t happen.
On the other hand, it would at least have been a clarifying calamity—the action-forcing event the EU still so badly needs. The risk today is that Europe’s weak, faltering recovery will be seen as good enough, making the changes that could restore Europe’s vitality much less likely to happen. Muddling through, ever the EU’s default mode, may be the worst possible outcome. Europe might find, to its ultimate cost, that the contradiction built into its economic system is tolerable after all. The price may not be another sudden breakdown—though this remains a possibility—but persistently high unemployment in many countries and chronic underperformance across the EU as a whole.
The basic contradiction was foreseen many years ago. In a single-currency system, policymakers lack the most powerful tool for helping individual economies adjust to setbacks: interest rates set according to national conditions. To succeed, a single-currency system needs either large fiscal transfers (so fiscal policy can do what monetary policy can’t) or highly integrated labor markets (so the unemployed can move to stronger markets to find work), and preferably both. The euro area has neither, and its governments, even after an epic sovereign debt crisis, have no plans to do much about it. This leaves the EU’s weakest economies with no choice but to restore their prospects through the brutality of “internal devaluation”—using high unemployment to force down labor costs.
The countries at the center of the crisis—Greece, Ireland, Portugal, and Spain—have all made heroic efforts to improve their competitiveness in the past four years, but they have more work to do. Meanwhile, their unemployment rates are 26 percent, 11 percent, 15 percent, and 26 percent, respectively. The commission expects little improvement in 2015. Two of the euro zone’s biggest economies, France and Italy, are in deep trouble as well, with unemployment above 10 percent and growth in 2014 expected to be 1 percent or less.
That would be bad enough by itself, but there’s a further danger. The Bloomberg Markets poll that found investors growing more optimistic about the EU’s prospects also reported mounting concern about the risk of deflation. Investors are right to be concerned. Inflation in the euro area stands at 0.7 percent, far below the European Central Bank’s target of “less than but close to 2 percent.” Next year the commission expects it to be 1.2 percent. Very low inflation maintains tight financial conditions by keeping real (inflation-adjusted) interest rates higher than they otherwise would be. Outright deflation would worsen that problem and further compound it by adding to the real burden of debt. The result would be prolonged economic stagnation and greater financial fragility.
It’s telling that in late January when the ECB announced it was conducting new stress tests of the EU’s banks—asking whether their capital was adequate to absorb losses if things should again turn out badly—deflation was not a risk the banks were told to consider. As a result, though better than the previous such exercise, the new stress tests are far from reassuring. Europe’s banking system remains vulnerable to crisis, and its regulatory reforms to date have been woefully lacking.
Governments have acknowledged the need to create a banking union capable of defending the financial system against a new collapse of confidence. That’s a step in the right direction, but there’s still no common fund for deposit insurance, for instance. The system for resolving failed banks is also seriously underpowered. A mere €55 billion ($75.4 billion) will eventually be allocated for the purpose—1 percent of the bank deposits in question, far too little to cope with a crisis.
Easier monetary policy would lessen the danger of deflation and the financial risks that go with it, but the ECB has been painfully slow to act. At recent policy meetings, the ECB’s Governing Council has discussed ways to deliver new stimulus; on May 8 the bank’s president, Mario Draghi, told investors that new steps would probably be taken next time.
What’s wrong with now? Quantitative easing like that employed by the U.S. Federal Reserve and the Bank of England is long overdue. Yes, the ECB faces legal complications, but these could be overcome. Certain forms of QE, such as using newly created euros to buy U.S. Treasury securities (as opposed to buying the debt of euro-area governments) are plainly within the ECB’s competence.
Meanwhile, on fiscal-policy cooperation, the EU has achieved next to nothing. Back in 2012, German Chancellor Angela Merkel said, “We need more Europe; we need more cooperation.” She even advocated fiscal union. It hasn’t happened, and her attention to German sensibilities is a main reason why. Merkel is popular at home because she has resisted the idea that German taxpayers should be put any more firmly on the hook for the economic problems (largely self-inflicted, in the German telling) of their EU partners. By “more Europe,” Merkel meant tighter restrictions on the ability of EU members to borrow, not greater cooperation in using fiscal policy to fight unemployment.
At Germany’s urging, the EU has therefore been forced to adopt an austerity-first stance. Italy and others have little choice but to squeeze public spending, since the recession has left them with insupportable public debts. The chances of a coordinated EU fiscal policy to relieve that pressure—for instance, by creating eurobonds backed by euro-area governments acting in concert—now seem close to nil. Excessive fiscal conservatism has aggravated the deflationary effects of an unduly passive monetary posture.
The single currency was bound to make macroeconomic policy in the euro area more difficult, but it didn’t have to be as ineffective as this. Merkel’s prescription in 2012—“more Europe”—was correct. The single currency requires a true banking union and fiscal flows across the EU comparable to those across the U.S., as well as longer-term measures to integrate the union’s labor markets. But Germany doesn’t want this; nor, it seems, do voters elsewhere in the EU. The May 22-25 elections to the European Parliament are expected to return populist anti-EU candidates in strength. This understandable backlash against a system that has performed so badly will make matters worse.
The popular mood is for less Europe, not more. So long as the euro system is in place, however, less Europe cannot be the answer. If the will to complete the single-currency project is lacking, the EU will be shackled to a system that all but guarantees poor performance and recurring political frictions. It’s a grim conclusion, but a crisis sufficient to break the system apart might have been in Europe’s best interest.