Wednesday, November 26, 2014

A Breach in the Eurozone Dike

PRINCETON – While all eyes have been on the European periphery, has the core been cracking? The Bundesbank has lowered its forecast for German annual GDP growth in 2013 to 0.4%. The Central Bank of the Netherlands expects Dutch GDP to shrink by -0.5% this year – following a contraction of about 1% in 2012.

The eurozone crisis may be entering its third stage. In the first stage, beginning in the spring of 2008, the locus of the North Atlantic crisis moved from the United States to the eurozone. Banks in the eurozone came under pressure, and interbank tensions increased.

In the second stage, starting in the spring of 2009, the crisis spread to the sovereigns, as investors grew increasingly worried that propping up banks would strain government finances. In turn, sovereign weakness made the banks appear riskier, and the banks and their home governments became joined at the hip.

Throughout the crisis, it has been widely assumed – at least so far – that the eurozone core would remain solid, and would continue to write the checks for the periphery’s distressed governments and banks. That assumption appeared plausible. A “two-speed” Europe was the new normal.

In particular, Germany stood above the fray. Following strong performance in 2010, Germany’s GDP exceeded pre-crisis levels by early 2011, a somewhat better achievement than that of the US. Indeed, given Germany’s surprisingly impressive employment performance, another Wirtschaftswunder appeared to be in the making.

Then a subtle change occurred. The US – despite a historically slow return to normalcy – pulled ahead of Germany. Absent a prolonged fiscal-cliff and debt-ceiling mess, the US may be cobbling together a sustainable recovery. Following the German economy’s sharp contraction in the last quarter of 2012, the question for the country today is whether it can avoid a technical recession (defined as two consecutive quarters of economic contraction).

Europe does not have its own growth engine. The German rebound was initially robust because world trade rose rapidly after a precipitous fall. China’s voracious appetite for German cars and machines provided the needed boost, even as Germany’s traditional trade partners in Europe struggled.

Since then, however, Chinese demand growth has slowed, and Germany’s European trading partners are in even deeper trouble. Fiscal austerity in the periphery requires cutting back on imports; hence, the countries exporting to the periphery need to curtail their own imports – and so the process cascades. This trade multiplier is causing European economies to drag each other down, and the rest of the world is feeling the effects.

The Dutch economy’s poor prospects are similarly alarming. The Netherlands is second only to Germany in the volume of credit that it channels through the so-called “Target 2” system to the eurozone periphery, and it is the periphery’s largest creditor in per capita terms.

Economic forecasters continue to promise that growth will revive. Things will begin to look up in the second half of 2013, we are told. But the track record of charting this recovery has been discouraging. In his book The Signal and the Noise, the American statistician Nate Silver says that forecasters perform worst when faced with a circumstance that they have not encountered before. This is such a circumstance.

In April 2010, the International Monetary Fund’s World Economic Outlook projected 1.8% annual GDP growth in Germany and the Netherlands in 2013. In October of last year, the IMF lowered its 2013 growth forecast for Germany to 0.9% and to 0.4% for the Netherlands. And, a mere two months later, both countries’ central banks report that even these reduced expectations are too optimistic. Who is to say that the second half of 2013 will bring more hope and cheer?

The European crisis-management process has been predicated on the Scarlett O’Hara principle that “tomorrow will be a better day.” Although everyone knows that postponing hard decisions only makes the problem larger, they could still believe that there would always be a firm line of defense. That may be changing.

The third stage of the eurozone crisis will arrive when the economic strength of the core is in doubt. Those very doubts undermine the credibility of the safety net that has been supporting the European periphery.

A solution to the eurozone crisis that relies on Germany has always been politically uncertain. It may soon become economically untenable.

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    1. CommentedScott Urban

      Interestingly, Germany's big expansion in the beginning of the crisis was due to a big government expansion in the national accounts, more than a net export boom.

    2. CommentedFrank O'Callaghan

      The whole world is more productive than it has ever been. It is now possible to produce more with less input than at any time in history. Per capita wealth is greater than ever and is likely to continue increasing. War, the single greatest destroyer of wealth, is almost unthinkable anywhere but even more so in Europe.
      So we have peace and prosperity? No, we have the twin problems of unemployment and inequality. We can solve these problems by redistribution.

    3. CommentedPaul A. Myers

      OK, let's accept that the third stage of the crisis will arrive in 2013 with no growth or worse in the core.

      What "hard" decisions should be made today that have been put off in the past?

      The hard decision that comes to my mind is to write down all the bank assets to fair market value. Then recapitalize the banks. The write off would be a paper loss; the recapitalization would at least involve the start of transferring real assets into the banking sector.

      After bank repair, what other "hard" decisions need to be made?

    4. CommentedPaulo Sérgio

      If "Europe", and here I mean European Union, does not have a growth engine, does it have a common market?