The Italian statistics office announced Aug. 6 that the country had fallen back into recession after two consecutive quarters of gross domestic product contraction (-0.1 percent in the first quarter, and -0.2 in the second). Italy had briefly emerged from a two-year recession in the final quarter of 2013 but only in a technical sense; its GDP grew by 0.1 percent. This means that the Italian economy has not grown for at least three years.
It is clear that 2014 will not be the year of economic recovery in Italy. When Prime Minister Matteo Renzi took over the Italian government in February, he promised to introduce one reform each month to reactivate Italy's stagnant economy. But he soon discovered what his predecessors had also found: Italy's political system is so fragmented, and the vested interests of different groups (from political parties to trade unions and business lobbies) are so strong, that it is impossible to apply such a bold program of reforms. Like former Prime Ministers Enrico Letta and Mario Monti, Renzi saw his good intentions fall victim to an endless fight in the Italian Parliament, with even some members of his own party voting against his proposals.
This will not be the year of substantial economic growth in France, either. President Francois Hollande is approaching the halfway point of his five-year mandate and has managed to apply only a handful of reforms. During his first year and a half in power, Hollande based his policy on tax hikes and limited spending cuts, seeking to avoid significant impacts on France's generous welfare state and oversized public sector. By late 2013 he realized that this strategy was not working, and in January he announced plans to reduce taxes for companies hiring new workers and implement spending cuts to reduce France's deficit. Like Renzi in Italy, Hollande saw significant resistance to his proposals, even from lawmakers in the ruling Socialist Party. The European Union expects France's economy to grow by 1 percent this year, but this forecast seems too optimistic.
In France and Italy, no economic growth means more problems reducing their deficits and debts and more difficulties reaching political and social consensus. It also means fewer possibilities for reducing unemployment and appeasing social unrest. At a time when unemployment is slowly falling in Spain, Ireland and Portugal, it is at 10.2 percent in France and 12.3 percent in Italy, according to Eurostat. High unemployment means weaker domestic consumption, less supply of and demand for credit and less tax revenue for the state. In other words, France and Italy are trapped in a vicious circle of weak governments, growing social unrest and poor economic activity. This, in turn, means an ongoing threat to their banking sectors as companies and households find it harder to pay back their loans.
The Political Nature of the Crisis
Things have substantially changed in Europe since late 2011, when bond yields in Italy reached record high levels and markets and politicians started to question whether the eurozone would collapse. The European Central Bank's promise of intervention in debt markets has brought substantial calm to financial markets, and most members of the eurozone are managing to issue debt at tolerable prices.
But as Stratfor said early in the European crisis, the European Union's problems are not just financial; they are eminently political as popular support for the ruling elites decreases and EU members fail to reach a consensus on what to do with the continental bloc. France and Italy have a similar view of what the process of European integration should look like. Paris and Rome defend a European Union in which softer deficit targets are allowed, the euro is weakened and Brussels finances substantial development programs to create jobs in the European periphery. The debate about these measures will dominate the bloc during the final months of 2014 and throughout 2015, but little progress is expected.
Germany is willing to tolerate some of these proposals but only to a certain extent. In recent years, the European Commission has turned a blind eye to excessive deficits and granted more time for countries to meet their targets. The problem is that France and Italy are now demanding a rewriting of the rules to make them explicit, something that Germany cannot accept.
Germany has also softened its position on France and Italy's proposal to allow the European Central Bank to apply quantitative easing, a decision that could technically weaken the euro and generate some inflation. However, Berlin understands that this measure would be controversial at home, both politically (voters could oppose it) and institutionally (the Constitutional Court could declare it illegal). As a result, it will try to delay as long as possible.
Finally, Germany, along with the United Kingdom, actually pushed for a reduction of the European Union's budget in late 2012. In recent years, EU-sponsored programs to create jobs, especially for young people, have failed. In the coming months the bloc will probably debate a larger program in which additional EU funds are allocated.
These examples show the variation among the three largest eurozone economies' views of what the European Union's future should be. We can expect some flexibility from Germany on some of the French and Italian proposals, but a complete overhaul of the bloc's institutional framework and policies seems unlikely given the current political fragmentation.
Growing Domestic Problems for Paris and Rome
Hollande and Renzi will thus face more difficulties at home. The French political system has been designed to be stable, and Hollande's government is not currently at stake, but popular support for the president remains extremely weak. After the summer break, France will probably see a new wave of protests and strikes and a rise in support for Marine Le Pen's anti-establishment National Front. The National Front's growth in popularity will be a critical factor discouraging Hollande from calling for early legislative elections. However, elections cannot be ruled out before his presidential term ends in 2017.
The situation is similar in Italy but with a key difference: The Italian political system is not nearly as solid as the French system. In May, the ruling Democratic Party saw a record performance in the elections for the European Parliament. But since then, economic conditions have not improved in Italy, and Renzi's bold reform plans have stalled. As in France, almost nobody in the Italian government wants elections now, but if circumstances keep deteriorating the government could decide to hold them before its popularity erodes further. In any case, Italy, like France, will probably see protests and strikes after the Continent's summer break.
France and Italy will not leave the eurozone anytime soon. Fear of the unknown consequences of such a move, along with a deep ideological conviction in their center-left governments regarding the need to preserve the continental bloc, will prevent such a decision. But political and ideological fragmentation in the European Union will deepen, making consensus increasingly difficult within the bloc. The danger for France and Italy is that social unrest will become so strong that Paris and Rome make drastic decisions that, at this point in the crisis, still seem unlikely.