MILAN – A knowledgeable friend in Milan recently asked me the following question: “If an outside investor, say, from the United States, wanted to invest a substantial sum in the Italian economy, what would you advise?” I replied that, although there are many opportunities to invest in companies and sectors, the overall investment environment is complicated. I would recommend investing alongside a knowledgeable domestic partner, who can navigate the system, and spot partly hidden risks.
Of course, the same advice applies to many other countries as well, such as China, India, and Brazil. But the eurozone is increasingly turning into a two-speed economic bloc, and the potential political ramifications of this trend are amplifying investors’ concerns.
At a recent meeting of high-level investment advisers, one of the organizers asked everyone if they thought the euro would still exist in five years. Only one person out of 200 thought that it would not – a rather surprising collective assessment of the trending risks, given Europe’s current economic situation.
Right now, Italy’s real (inflation-adjusted) GDP is roughly at its 2001 level. Spain is doing better, but its real GDP is still around where it was in 2008, just prior to the financial crisis. And Southern European countries, including France, have experienced extremely weak recoveries and stubbornly high unemployment – in excess of 10%, and much higher for people younger than 30.
Sovereign debt levels, meanwhile, have approached or exceeded 100% of GDP (Italy’s is now at 135%), while both inflation and real growth – and thus nominal growth – remain low. This lingering debt overhang is limiting the ability to use fiscal measures to help restore robust growth.
The competitiveness of eurozone economies’ tradable sectors varies widely, owing to divergences that emerged after the common currency was first launched. While the euro’s recent weakening will blunt the impact of some of these divergences, it will not eliminate them entirely. Germany will continue to run large surpluses; and countries where the ratio of unit labor costs to productivity is high will continue to generate insufficient growth from trade.
Since the 2008 financial crisis, the conventional wisdom has been that a long, difficult recovery for eurozone economies will eventually lead to strong growth. But this narrative is losing credibility. Rather than slowly recovering, Europe seems to be trapped in a semi-permanent low-growth equilibrium.
Eurozone countries’ social policies have blunted the distributional impact of job and income polarization fueled by globalization, automation, and digital technologies. But these countries (and, to be fair, many others) still must reckon with three consequential changes affecting the global economy since around the year 2000.
First, and closest to home, the euro was introduced without complementary fiscal and regulatory unification. Second, China joined the World Trade Organization, and became more thoroughly integrated into global markets. And, third, digital technologies began to have an ever-larger impact on economic structures, jobs, and global supply chains, which significantly altered global employment patterns, and accelerated the pace of routine-job loss.
Shortly thereafter, between 2003 and 2006, Germany implemented far-reaching reforms to improve structural flexibility and competitiveness. And, in 2005, the Multi-Fiber Arrangement lapsed. Without the MFA, which had underpinned quotas for textile and apparel exports since 1974, global textile manufacturing became heavily concentrated in China and, surprisingly, Bangladesh. In 2005 alone, China doubled its textile and apparel exports to the West. This development had a particularly adverse effect on Europe’s poorer regions and less competitive developing countries around the world.
These changes created a growth-pattern imbalance across a wide range of countries. As many countries took measures to address shortfalls in aggregate demand, sovereign debt increased, and debt-fueled housing bubbles expanded. These growth patterns were unsustainable, and when they eventually broke down, underlying structural weaknesses were laid bare.
Resistance to the current system is now growing. The United Kingdom’s Brexit referendum and Donald Trump’s election as US president both reflected public discontent with the distributional aspects of recent growth patterns. And rising support for populist, nationalist, and anti-euro parties could pose a serious threat to Europe as well, not least in large eurozone countries such as France and Italy.
Whether or not these parties succeed at the ballot box in the immediate future, their emergence should cast doubt on overly sanguine views about the euro’s longevity. Anti-euro political forces are clearly making electoral inroads, and they will continue to gain ground as long as growth remains anemic and unemployment remains high. In the meantime, the EU will most likely not pursue substantial policy or institutional reforms in the near term, for fear that doing so could adversely affect the outcome of consequential elections this year in the Netherlands, France, Germany, and possibly Italy.
Of course, an alternative view holds that Brexit, Trump’s election, and the rise of populist and nationalist parties will serve as a wake-up call, and spur Europe toward broader integration and growth-oriented policies. This would require EU policymakers to abandon the view that each country is solely responsible for getting its own house in order, while upholding EU fiscal, financial, and regulatory commitments.
Upholding EU rules is no longer practical, because the current system imposes too many constraints and contains too few effective adjustment mechanisms. To be sure, fiscal, structural, and political reforms are sorely needed; but they will not be sufficient to solve Europe’s growth problem. The bitter irony in all of this is that eurozone countries have enormous growth potential across a wide variety of sectors. Far from being basket cases, they simply need the system’s constraints to be loosened.
Will Europe’s future resemble a slow-motion train wreck, or will a new generation of younger leaders pivot toward deeper integration and inclusive growth? It is hard to say, and I, for one, would not dismiss either possibility.
One thing seems clear: the status quo is unstable and cannot be sustained indefinitely. Absent a marked shift in policies and economic trajectory, the political circuit breakers will be tripped at some point, just as they have been in the US and the UK.