More perils lie in wait for the eurozone

Divergence in the performance of members of the single currency is a real challenge

by: Martin Wolf

Events are testing the eurozone yet again. The latest shock comes from Italy, where Matteo Renzi’s comprehensive defeat in the constitutional referendum has caused his resignation. Italy, which has the eurozone’s third-largest economy, is an important country. Mr Renzi’s departure may not prove a decisive event. But, so long as the eurozone fails to deliver widely shared prosperity, it will be vulnerable to political and economic shocks. Complacency is a grave error.
Things are at least improving. Eurozone real gross domestic product expanded by 5.5 per cent between the first quarter of 2013 and the third quarter of 2016. Unemployment fell from a peak of 12 .1 per cent in June 2013 to 9.8 per cent in October 2016. Thus growth is running above potential.

Yet this improvement has not offset the damage done by the financial crisis of 2008 and the eurozone crisis of 2010-12. In the third quarter of 2016, the eurozone’s aggregate real GDP was a mere 1.8 per cent higher than in the first quarter of 2008. Remarkably, real domestic demand in the eurozone was 1.1 per cent lower in the second quarter of 2016 than it had been in the first quarter of 2008. This extreme weakness of demand should not have happened. It represents a huge failure. (See charts.)

A direct way of identifying that failure is in terms of nominal demand. In the second quarter of 2016, eurozone nominal demand was only 6.9 per cent higher than in the first quarter of 2008.

So what should it have been? Assume the trend rate of real growth is 1 per cent, while the inflation target is close to 2 per cent. Then nominal demand ought to grow at about 3 per cent a year. If policymakers had achieved that, nominal demand would have risen by about 28 per cent between the first quarter of 2008 and the second quarter of 2016. That must be too much to ask. But US nominal demand rose by 23 per cent over this period. Moreover, the weakness of demand also had a strong downward effect on inflation. Year-on-year core inflation has not exceeded 2 per cent since January 2009 and has averaged just 1.2 per cent since that date.
A severe challenge is the divergence in economic performance among the members of the single currency, with deep recessions in a number of member countries (notably Italy) and stagnation in others (notably France). According to the Conference Board, a research group, between 2007 and 2016 real GDP per head at purchasing power parity rose 11 per cent in Germany, barely changed in France, and fell 8 per cent in Spain and 11 per cent in Italy. It will probably take until the end of the decade before Spanish real incomes per head return to their pre-crisis levels. In Italy, this seems unlikely to happen before the mid-2020s. The painful truth is that the eurozone has not only suffered poor overall performance, but has also proved to be a machine for generating economic divergence among members rather than convergence.

Italy has a problematic banking sector, with some €360bn in non-performing loans. Yet this is mainly the result of the deep and prolonged slump. If this continues, still more bad debt is likely to emerge.

The inability to agree on how to resolve the banking crisis in ways that meet the constraints of Italian politics on the one hand, and of European rules calling for bail-ins, rather than bailouts, on the other, is now a canker in Italy’s politics.

One encouraging development, however, is the signs of shifts in competitiveness in the eurozone. One indicator is relative wages. Before the crisis, average wages rose markedly in France, Italy, Spain, Greece and Portugal, relative to German levels. This has been at least partly reversed since then. Other things being equal, this should help restore balance within the eurozone’s economy.

Nevertheless, the disappearance of the pre-crisis current account deficits in crisis-hit eurozone countries is largely due to severe collapses in their real demand. In the third quarter of 2016, Italy’s aggregate real domestic demand was 10 per cent lower than in the first quarter of 2008, while Spain’s was still close to 11 per cent lower, as it recovered from its post-crisis fall of nearly 19 per cent. Germany’s real demand has risen by 8 per cent over the same period. But its current account surplus has risen from 7 per cent of GDP in 2007 to a forecast of just under 9 per cent in 2016. This is yet another failure in internal eurozone adjustment and makes it too dependent on a large external surplus.

The combination of weak aggregate demand with huge post-crisis divergences in economic performance has turned the eurozone into an accident waiting to happen. True, it is quite possible that the situation will stabilise. But the interactions between economic and financial events and political stresses are unpredictable and dangerous.
What the eurozone needs most is a shift away from the politics of austerity. In its most recent Economic Outlook, the OECD, a club of mostly rich nations, makes a cogent (albeit belated) plea for a combination of growth-supporting fiscal expansion with relevant structural reforms.

This is most relevant to the eurozone because that is where demand has been weakest and the fetish over fiscal deficits most exaggerated. In the big eurozone economies, net public investment is near zero. This is folly.

Alas, little chance of change exists. Those who matter — the German government, above all — view public borrowing as a sin, regardless of its cost. The political and economic impact of breaking up the eurozone is so great that the single currency may well soldier on forever. But it has by now become identified with prolonged stagnation. Those member countries with the power to change this approach should ask themselves whether it really makes sense. It is time for the eurozone to stop living dangerously and start living sensibly, instead.

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