Sunday, October 26, 2014
Eurozone starts to look a lot like Japan
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


My regular column is available to subscribers on This is an excerpt.

How worried should we be about the eurozone? Is the single currency area, the weakest link in the global economic chain since the crisis, about to enter its third recession in the space of little more than six years? Worse, are those fears of euro break-up, which paralysed business and consumer confidence, returning?

The Bank of England is clearly concerned. Though two members of the monetary policy committee (MPC), Martin Weale and Ian McCafferty, continued to vote for higher interest rates this month, most MPC members were concerned, among other things, about the impact of the eurozone on Britain’s economy.

“There was mounting evidence of a loss of momentum in the euro area, including in Germany, where growth appeared to have stalled and industrial production had fallen sharply,” the MPC’s October minutes said. And: “Further downside news in the euro area had increased the risks to the durability of the UK expansion in the medium term.”

Today is quite a big day for the eurozone. The results of the Asset Quality Review (AQR) for the eurozone’s banks will be published, ahead of the European Central Bank taking responsibility for euro area banking supervision on November 4.

Though these stress test exercises have been criticised in the past for being too soft, there have been reports that up to 10% of the 130 banks covered will fail. The aim of the exercise is to demonstrate that the eurozone’s banking system is secure. At the margin, however, some banks will have to raise additional capital and this will depress bank lending.

The big picture in the eurozone, which the Bank of England was responding to, is one of desperately weak growth and very low inflation. Eurozone gross domestic product was flat in the second quarter and up by just 0.7% on a year earlier. The best that can be hoped for in coming quarters is growth of 0.1% or 0.2%. The fear is that GDP will turn negative again, following the recessions of 2008-9 and 2011-13.

Unemployment, while down from its highs is nevertheless 11.5%, 18.3m people, with a rate of 23.3% for young people.

Inflation is down everywhere but it is down particularly in the eurozone, averaging just 0.3% last month. Five of its members, Greece, Spain, Italy, Slovakia and Slovenia, have negative inflation; deflation. Several others are very close to it.

So how bad is it? I always have mixed feelings writing about the eurozone. On the one hand this is a system which, as some of us warned repeatedly, combines the worst of all worlds. Europe’s politicians over-reached themselves in launching and expanding a system which defied economic logic. The eurozone’s problems were entirely predictable.

A grouping of a small number of similar economies might have worked but once the euro became effectively open to all trouble was inevitable. As it is the long-term future of the eurozone rests on creating the conditions for what economists would call an optimal currency, which means some kind of central Treasury or properly co-ordinated fiscal policy, wage flexibility and genuine geographical mobility of labour. Incidentally, free movement of people is much more important for euro members than for non-euro EU countries such as Britain.

All that will take a long time, if it can ever be achieved. It means supply side reform, and it means institutional reform, and it will mean individual euro members accepting a loss of control of fiscal as well as monetary policy. Many are unwilling to do that.

I do not in any way celebrate the eurozone’s problems. It was the biggest single factor holding back Britain’s recovery, and it remains the biggest factor preventing a rebalancing of the economy towards exports.

The eurozone’s current woes are, however, slightly different to those of a couple of years ago, when Europe was staring into the abyss. Ireland, after its harsh austerity programme, is now showing remarkable growth, with GDP up an astonishing 7.7% over the past year. Spain is also picking up as, somewhat more patchily, is Portugal. Greece remains a problem but may also be ready to return to modest growth.

The problem is in the eurozone’s core, with France at best stagnant – no growth at all over the latest six months, Italy already in its third recession in the space of a few years and Germany on the brink after a disastrous August and a 0.2% drop in GDP in the second quarter.

These “core” eurozone economies are not going to leave the single currency, which was the big fear with Greece and some of the other peripheral economies. But their weak performance will weigh down on the rest and, as long as it continues, make it hard for the eurozone as a whole to stage a decent recovery.

What can be done? The European Central Bank, having cut interest rates to rock bottom and then reduced them further, is running through its unconventional “whatever it takes” monetary policy options, to include purchases of covered bonds, asset backed securities and perhaps eventually full-blown quantitative easing, involving government bond purchases.

What about fiscal policy and the infrastructure spending recommended to boost the eurozone by the International Monetary Fund and others? This should be looked at, though we should be realistic about the hurdles.

The eurozone’s budget deficit last year was 2.9%, about half that in Britain, according to Eurostat data based on the new methodology, the so-called ESA2010 data. The trouble is that the deficits were unevenly spread. Greece, for example, still had a deficit of more than 12% of GDP. France’s was 4.1%, still above what the EU authorities regard as acceptable. Italy’s deficit is 2.8% of GDP, but alongside debt of 128% of GDP, compared with a high eurozone average of just over 90%.

A few countries have scope for a fiscal boost. Germany has a budget surplus of 0.1% of GDP, beaten only by Luxembourg with 0.6%. Some others, such as Austria and the Netherlands, have relatively small deficits.

Germany, however, appears to be an immovable object on relaxing fiscal policy and boosting infrastructure spending, insisting on protecting a balanced budget which is now enshrined in law.

An infrastructure boost in Germany would, in any case, while generating some extra growth in the Federal Republic, have a limited effect elsewhere. The eurozone crisis has evolved. Its slow growth, which is starting to look rather like Japan, is here to stay.