Taking the Shine Off European Growth

10 MINS READAug 12, 2015 | 09:15 GMT
The chart of Germany's share index DAX is displayed at the stock exchange in Frankfurt.
Forecast Highlights

  • It is unclear whether the apparent improvements in some European economies will be sustainable.
  • The optimism surrounding these economies could actually be dangerous if it bleeds into the markets.
  • Pressure will continue to rise on Germany to subsidize other eurozone countries.

While the world's attention has been focused on the drama in Greece, a different narrative has been forming around the rest of the eurozone economy. It is a story of moderate recovery and return to growth, and it carries the message that Europe, which taken together is the world's largest economy, has finally turned a corner.

Germany, the Continent's economic driver, has continued to record high export numbers and low unemployment, and the current account surplus, prided by Germans, was a hefty 7.4 percent in 2014. Spain, the monetary union's fourth largest economy, is growing beyond all expectations, and the Bank of Spain recently raised its growth forecast from 2.8 to 3.1 percent for 2015. Considering how difficult the past seven years have been for Spain, these numbers are indeed impressive. Even France and Italy, Europe's second and third largest economies, appear to be shaking themselves from their torpor and seem poised to register growth of 1.3 percent and 0.7 percent respectively, according to World Bank projections. (In 2014, France grew by 0.2 percent and Italy shrunk by 0.4 percent.) Meanwhile some of Europe's smaller states such as Ireland and Portugal, which have caused problems for the union in the recent past, have also seen marked improvements in their headline figures. Ireland has stood out in particular, boasting Europe's fastest growth rate in 2014. These positive numbers, however, raise the question of whether Europe's recent growth is truly sustainable. The years between the birth of the euro in 1999 and the 2008 economic crash were also marked by a great deal of growth. But this growth came at a huge cost: The financial crisis revealed that the boom had been fueled by credit, which now weighs heavily on Europe's balance sheets.

But things might be different this time. There are temporary circumstances that are at least partly to blame for the recent boost. In the second half of 2014, the price of oil fell by half to $50 per barrel, and though it has since fluctuated upward, it recently dipped back below the $50 mark. For oil importing countries — most of Europe — a low oil price acts in the same manner as an across-the-board tax cut. Companies see transport costs slashed and consumers find they have more money to spend because of low prices at the gas pump. In addition to this price drop, 2014 also saw European Central Bank President Mario Draghi drop hints that he intended to undertake a policy of quantitative easing, a promise he fulfilled. The markets prepared by selling euros and buying government bonds. The resulting weak euro and high demand for government debt has had twin positive effects for eurozone countries: The weak currency increased the global competitiveness of exports, while low interest repayments took some pressure off Europe's heavily indebted nations. Neither low oil prices nor quantitative easing are likely to disappear in the immediate future, but it is important to note that both are short-term stimuli that cannot be relied upon in the long run (though it is still possible that this could be the new normal for oil prices).

What Spanish Unemployment Conveys

Spain's recent growth, meanwhile, becomes much more complex when studied closely. The 2012 bailout of Spain's banking system — like the bailouts in Ireland, Portugal, Cyprus and Greece — came attached to various structural reforms designed to increase the country's overall competitiveness. In theory, these measures would allow the eurozone periphery to compete with the German export engine. Spain has managed to lower its wage growth to ultimately negative levels, a striking feat when compared to France and Germany where wages continued to grow. The idea underpinning the reforms is that Spain's membership in the eurozone constrains its ability to devalue its currency, so it must instead devalue its inputs — in this case, wages — to regain competitiveness, including against its eurozone peers. But Spain's recent growth does not seem to have been achieved through the intended export-led model; it is instead being driven by domestic demand.

Spain's trade balance, having reached a surplus in 2013, has now dipped into deficit, meaning that Spain is now importing more goods and services than it is exporting. By means of comparison, Germany, whose economic model is the ultimate goal of reform attempts, had a trade surplus of 7.5 percent of gross domestic product in 2014 while Spain had a 1.7 percent deficit. A closer look at some of Spain's other recent successes is also sobering. Though it is true that Spain's unemployment has dropped to its lowest level since 2011, unemployment is still at 22.4 percent, the second highest in Europe by far. Moreover, a quarter of the jobless are long-term unemployed, and Spain's overall youth unemployment still hovers just under 50 percent. The combination of high long-term and youth unemployment reflects a young generation that has missed out on the formative post-university years of work. Assuming Spain does manage to continue creating jobs for its unemployed, which is a big assumption, it might be hard to find these lost youth — who are often called "ni-ni's," meaning neither-nor, since they neither work nor study — any kind of meaningful employment.

Furthermore, the political driver of Spain's economic trajectory is likely to disappear soon. The ruling People's Party is facing elections at the end of this year and has relaxed some of its fiscal austerity to help build momentum. Such fiscal laxity is unlikely to last far into 2016 if the party retains power. (If a leftist coalition that includes the Spanish Socialist Workers' Party and Podemos wins, spending will likely increase but will soon run into fiscal barriers.) The fact is that Spain's underlying numbers still look very weak. Spain has a debt to GDP ratio of 98 percent, high private debt levels and a 2014 budget deficit of 5.8 percent, which is far above the 3 percent required by the European Union. This means that the country has little room to stimulate growth through more credit, which again raises questions about the sustainability of its current expansion. Shaky growth in Spain also has ramifications elsewhere: Portugal's exports have recently been boosted by Spanish demand, and thus could decline as Spain slows down again in 2016.

Broad Uncertainty

Among the eurozone's "Big 4" — Germany, France, Italy and Spain — the picture does not look any rosier. If Italy is not struggling with a budget deficit problem of the same scale as Spain's, it is only by the grace of European Central Bank President Mario Draghi and his quantitative easing program. Italy's debt amounts to 132 percent of its GDP, the second highest in the European Union after Greece, and its S&P credit rating hovers just one notch above junk status. In an unconstrained market, Italy would be paying a much higher interest rate on this debt, deeply affecting the government's budget, but the European Central Bank's willingness to buy Italian bonds has caused interest rates to fall extremely low for the time being. This support will only work for as long as it is applied, however, and the quantitative easing program is currently scheduled to end in September 2016. In the meantime, Italy and neighboring France have shown only meager stirrings of growth and unemployment loiters above 10 percent in both countries. In Italy's case, unemployment, 12.7 percent in June, appears to still be growing. France also suffers from high debt, currently 95 percent of GDP, and has had run-ins with the European Commission over its high budget deficit, which stands at 4 percent.

Before the creation of the eurozone, the French and Italian financial problems would have had a clear solution. Unlike Germany, which has a deep intolerance of inflation, France and Italy have regularly used currency devaluation and inflation to increase competitiveness and reduce debt levels. Such maneuverings were notably employed during the 30-year period after World War II, in which the Bretton Woods financial system and the U.S. implementation of the Marshall Plan coincided to create the perfect circumstances for growth.

The prospect of a lasting currency devaluation is now of course complicated by the fact that both are members of a single currency, and any plan for engineering high inflation immediately encounters two barriers. First, the European Central Bank is constructed on a German model and thus geared primarily toward keeping inflation levels down. Second, since the members of the eurozone are bound together in a single currency, the only methods of increasing competitiveness through Germany are by internal devaluation, as seen in Spain, or by reducing inflation lower than Germany. However, Germany is unlikely to willingly allow its own inflation to soar so its eurozone colleagues can inflate away their debt while maintaining competitiveness. Thus Europe's second and third largest economies are trapped with low growth, high debt and high unemployment, and this during a period in which the economic climate is supposed to be relatively favorable.

Incidentally, Ireland, another recipient of a bailout with reforms attached, has had more success in adopting the German model. Its impressive growth has coincided with an increase in its trade surplus since the crisis struck, and its exposure to the fast-growing British economy has also helped. Unfortunately, Ireland's small size (just 1.3 percent of the EU economy) means that it is unlikely to make a dramatic impact on the overall picture.

The German plan, which advocated that Europe's Mediterranean states solve their economic problems by increasing their competitiveness and thus transforming to a German model, appears to be failing, or at least moving too slowly to avert a disaster, such as the loss of confidence in Italy's ability to pay its debt. The World Economic Forum's Global Competitiveness Report for 2014 revealed that not one Mediterranean country is among Europe's top 10 most competitive economies, and they are mostly stagnant. Comparing their positions to the equivalent 2011 report, France has slipped from 18th to 23rd in the world and Italy from 43rd to 49th. Spain has improved its position but only by one place, putting it 35th in the world and 16th in Europe.

Thus talk of a European recovery appears to be premature. Spain, the one large country that is posting newly impressive growth figures, has not managed to base this growth on exports, and it still suffers deep underlying weaknesses, like its counterparts in France and Italy. Indeed, Spain's recent growth may actually create problems for its peers if the positivity spreads to the markets and investors begin to move funds out of bonds and into more growth-friendly instruments. This would increase government borrowing costs across the Continent irrespective of quantitative easing, which would be particularly painful for Italy. Since the financial crisis of 2008, Germany has been repeatedly asked whether it is willing to subsidize its less competitive neighbors for the sake of the union. Up until now it has been postponing answering the question, preferring instead to focus on improving its neighbors' competitiveness. These attempts appear to be failing, and sooner or later Germany will face pressure to subsidize its neighbors once more. And each time the issue comes up, a decision on the matter becomes harder to avoid.

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