Saturday, October 25, 2014
9

Europe’s Fake Normal

NEWPORT BEACH – August is traditionally Europe’s holiday month, with many government officials taking several weeks off. In the process, important initiatives are put on hold until the “great return” at the beginning of September.

This year, there is another reason why Europe has pressed the pause button for August. With a looming election in Germany, few wish to undermine Chancellor Angela Merkel’s likely victory. After all, Germany is central to Europe’s well-being, and Merkel’s steady hand has allowed the continent to overcome a series of challenges over the last few years. As a result, many are eager to postpone any controversial policy decisions rather than rock the German political boat.

Some of the recent economic news has seemed to justify this approach. At the end of July, the widely watched indicator of European manufacturing activity crossed the threshold signaling expansion for only the second time in 23 months.

Adding to the sense of comforting normality, several European officials have taken to the airwaves with optimistic pronouncements. Whereas the euro and the eurozone were “under threat just nine months ago,” European Council President Herman Van Rompuy recently declared, “this isn’t the case anymore.”

All of this has underpinned a much-welcome calm in financial markets. Sovereign interest-rate spreads have been well-behaved, the euro has strengthened, and equity markets have risen robustly.

Yet no one should be fooled. This summer’s sense of normality is neither natural nor necessarily tenable in the long term. It is the result of temporary and – if Europe is not attentive – potentially reversible factors. If officials do not return quickly to addressing economic challenges in a more comprehensive manner, the current calm may give way to renewed turmoil.

The task for Europe is not just a matter of restarting and completing the economic and political initiatives, whether regional or domestic, that have been put on hold until after the German election. In fact, these top-down decisions, while admittedly complex and certainly consequential, may be the least of Europe’s challenges.

Europe must also counter and reverse micro-level challenges that are becoming more deeply embedded in its economic and financial structure. Each day that passes complicates the design and implementation of lasting solutions to four problems in particular.

First, joblessness continues to spread. The overall unemployment rate (12%) has yet to peak, led by an alarming lack of jobs among the young (24% joblessness in the eurozone as a whole, with highs of 59% and 56% in Greece and Spain, respectively).

Second, adjustment fatigue is widespread and becoming more acute. Long-struggling European citizens – especially the long-term unemployed – have yet to gain any sustained benefit from the austerity measures to which they have been subjected. And the result is not just general disappointment and worrisome social unrest. In the last few weeks, political stability in Greece and Portugal has been threatened as governments struggle with declining credibility and a rising popular backlash.

Third, bailout fatigue is apparent. Citizens in the stronger European economies are increasingly unwilling to provide financial support to their struggling neighbors; and their elected representatives will find it hard to ignore growing resentment of repeated diversion of national tax revenues, which has yielded only disappointing outcomes. Meanwhile, high levels of past exposure and weakening creditor coordination are undermining the availability of external funding, including from the International Monetary Fund.

Finally, little oxygen is flowing to the private sector. While Europe has succeeded in stabilizing its sovereign-bond markets, financial intermediation for small and medium-size enterprises remains highly disrupted. With most credit pipelines already partly blocked, the shortage of corporate credit will become more severe as regulators finally force banks to embark on a proper mobilization of prudential capital and shrink balance sheets to less risky levels.

All of this adds up to a sad reality for Europe. Despite hopeful blips in an economic indicator here and there, too many countries lack both immediate growth and longer-term growth engines. As a result, debt overhangs will remain problematic. Owners of private capital that could be allocated to productive investment will remain hesitant. And societies will continue to lack the jobs and capital investment that are essential for durable prosperity and general well-being.

Europe’s external environment is not helping, either. On the demand side, the ongoing economic slowdown in China is starting to affect companies’ orders and revenues, adding to the challenges stemming from the persistently sluggish US economy. Meanwhile, the euro’s recent appreciation (particularly against the Japanese yen) limits Europe’s ability to compensate for anemic global demand by capturing greater market share.

These developments point to a much larger phenomenon: because of delayed awareness of the complex challenges (and the related slow and partial policy responses) facing much of the West, the low-equilibrium growth pattern that has prevailed in recent years (what has been called the “new normal”) is becoming less stable. And Europe is a leading indicator of this.

In essence, Europe (and the West more generally) owes its recent tranquility to a series of experimental measures by central banks to offset the troubling combination of too little demand to generate sufficient job creation, inadequate structural reforms to revamp growth engines, debt overhangs that undermine productive investment, and insufficient policy coordination. Consequently, the resulting surface calm masks still-worrisome economic and financial fundamentals.

Let us hope that European policymakers return well rested from their August break. They will need all the energy and dedication they can muster to pivot quickly from Europe’s forced normality to a more durable strategy for recovery, or at least to stop drivers of renewed prosperity from slipping farther away before they can be harnessed.

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  1. CommentedParrain Boursorama

    It is instructive that Professor Rogoff cites Harmston. The value of gold is more discussed than the value of bread but there is no doubt which one is the more important and it is not the value of the mineral. Malthusian limits will devalue gold in the long run.

  2. CommentedG. A. Pakela

    Austerity in Europe should be limited to the limitation of out-of-market compensation and benefit contracts for public service employees, which are unsustainable given the amount of tax revenue generated by the private sector. But, the stimulus should come from reducing taxes on consumption (the VAT) and investment (individual and corporate income taxes.) They need to do a Euro-version of Reagan voodoo economics - eliminate the corporate income tax and cut marginal tax rates on the rich. This will pump money into the private sectors as consumers have more money available to spend on goods and services. Will there be a deficit? So what, if you can get a government treasury yielding a fair return, and not one crimped by central bank market manipulation, you can spend the proceeds, returning the income back to the economy. Most readers must have conveniently forgotten just how high risk-free yields were in the U.S. in the early 1980's - over 10% even on short-term funds.

      CommentedCarol Maczinsky

      George, the solution is to abide to agreed principles and rules, not to weaken them. Everything else it Hold-Up and undermines the European spirit.

      CommentedGeorge Silver

      @Carol Maczinsky

      Since you declare yourself a European, you should remember we all share the same continent. We should do everything to protect her from situations that will take us back to dark eras.

      CommentedCarol Maczinsky

      Precisely spoken the Southern nations could do what they want, they are free to leave the Monetary Union and its principles and issue their junk currency. This crisis is their opportunity for reform and they should use it.

  3. CommentedR S

    In the end, there is no way around a debt restructuring in the EU periphery and a private sector based transfer union (banking union & debt-to-equity swaps in EU's banking sector) to solve EU's financial crisis. This is why:

    1.
    http://cubismeconomics.blogspot.co.uk/2013/04/eurozone-debt-restructuring-is-name-of_14.html

    2.
    http://cubismeconomics.blogspot.co.uk/2013/05/sprechen-sie-deutsch-martin-wolf-does.html

    3.
    http://cubismeconomics.blogspot.co.uk/2013/08/eurozone-survival-transfer-union-yes.html

  4. CommentedStepan February

    "delayed awareness of the complex challenges (and the related slow and partial policy responses) facing much of the West"

    Mr. El-Erian already writes in the oracular style of Mr. Greenspan. I see a Fed chairmanship in his future.

  5. CommentedPaul A. Myers

    I believe that Germany will lead a northeast European economic bloc of countries both inside and outside the euro to sustainable slow growth as a worldwide manufacturing complex. This will be satisfactory to the northern Europeans.

    The southern Europeans will drift at zero growth or slightly positive as inadequate structural reform is met with inadequate debt relief from the overall Euro Union. Temporary flare ups will be met by credit-granting techniques from the ECB or other funds sufficient to put out the flare up but not lead to an overall solution.

    So Europe will be some sort of two-speed economy until something more cataclysmic and less evolutionary comes along.

  6. CommentedKen Fedio

    All measures taken have been to maintain a system that is to everyone's opinion flawed. It's very surprising that there hasn't been a European Spring, yet. Maybe next year.

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