Eurozone downturn and lack of reform presage existential crisis

A slowdown mixed with a monetary union unwilling to repair itself would be a risk to the global economy

Wolfgang Münchau

Puzzling decline: German industrial production has been weak since December and European car sales fell 5 per cent in March © Bloomberg

Over the course of the past week, we learnt two new things about the eurozone. Germany has closed the doors on serious reform. Angela Merkel and Emmanuel Macron’s meeting in Berlin exposed deep differences about the German and French leaders’ visions of the future.

What also transpired more clearly is that there has been a sudden decline in the eurozone’s economic activity. The latter is puzzling. It could be a fluke, but a number of recent indicators have all surprised on the downside.

German industrial production has been weak since December. But it took a real dive in February, when it fell by 1.6 per cent against January. The European Automobile Manufacturers Association reported that car sales were down by 5.3 per cent in March. One of the more reliable gauges is the business cycle indicator of IMK, the German economic institute.

It now registers a recession probability of one-third, up from almost zero a month earlier.

Now add these two pieces of news together. We know for certain that Germany will not agree to a central eurozone budget to weather macroeconomic shocks. There will be no single safe asset.

There will be no common deposit insurance. The big project of a European banking union will remain forever uncompleted.

Then add something really dangerous — a recession — into the mix. I have no idea whether the next crisis will originate in sovereign bond markets, in the banking sector, or somewhere else. But the combination of a slowing and possibly retracting economy and a monetary union unwilling to repair itself constitutes one of the biggest risks to the global economy right now.

Can we be sure about the economic downturn? No, we cannot.

The confidence indicators may be temporarily affected by fears of a trade war. If President Donald Trump of the US prioritises China as his main target for trade sanctions, those fears may soon go away.

If not, then yes, the eurozone would be particularly vulnerable because of its large current account surplus.

There are also seasonal factors to consider. The winter was harsh in Europe — in the north and the south. That could have played a role in depressing industrial production and investor sentiment. The combination of a warm summer and a distracted US president may go some way to solving the problem. But there are other reasons to suspect that something else might be afoot.

The first has been the appreciation of the euro. The daily nominal trade-weighted exchange rate of the euro has increased by almost 7 per cent over the past year. For an economy with an extreme degree of export-dependency this is a big move. Most of the change occurred last year, but it would be normal for the economic impact only to become notable with a delay.

Second, the financial crisis may have lowered the eurozone’s potential output permanently. The reported strong growth rates during 2016 and 2017 could have been a blip — a temporary relief after years of austerity. What is now disguising itself as a downturn may in time be revealed as a return to a depressed normality.

Italy has registered almost no productivity growth since becoming a founding member of the eurozone in 1999. Yet, 2017 was a relatively good year for the economy. It matters a great deal whether a country with a debt-to-GDP ratio of 132 per cent can manage average real growth rates of less than 1 per cent or 2 per cent. That gap is the difference between solvency and insolvency. Italy is the best example of why eurozone reforms are existential. The EU has no instruments to cope with an Italian sovereign debt crisis. Italy is too big to fail and too big to save. The European Stability Mechanism, the rescue umbrella, is too small to cope. I have no doubt that the euro itself will survive in some form or other, but without reforms the risks of a fracture are greatly increased.

Even President Macron’s reform agenda does not fully address this problem. But it would at least open the door to the infrastructure that is needed to do the heavy lifting in a crisis — a single safe asset and a fiscal backstop to the financial sector. The German position has been to reject these ideas from the outset.

After years of following the eurozone debate, I have come to the conclusion that Germany will not agree to reforms unless it is confronted with a take-it-or-leave-it choice. A eurozone break-up would be a disaster for Germany. It would destroy the country’s export-led business model, and shrink its massive stock of external assets.

But it is the prevailing assumption behind the refusal to accept institutional reforms that such a challenge would never happen. This assumption is correct. For now.

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