Monday, 14 January 2013

Both Good News and Bad News for Europe in 2013

Your Neighbourhood Economist predicts less panic about Europe in 2013 but much work still remains to be done

The turmoil in Europe dominated the headlines in 2012 as high levels of public debt and sluggish economic growth both acted to make investors nervous.  More than the actual problems with the economy in Europe, the real damage was done by a lack of decisive action by the leaders in Europe creating inflated fears about possible defaults and countries breaking away from the Eurozone.  But politicians managed to just muddle through with a big dollop of help from Mario Draghi at the European Central Bank (for a reminder - see "Whatever it takes").  There have been signs that enough has been done to stave off concerns over the immediate future of the Eurozone and its members.  An apparent return to normality is some good news for the Eurozone in 2013 but it is only the beginning.  The bad news is that there still remains a long slog for many countries in Europe to regain economic viability in the face of large and growing levels of debt and economies weakened by a lack of competitiveness. 

The economy in Europe was shackled in 2012 by worries about whether the Eurozone could hold itself together.  The uncertainty prompted firms to hold back from investing in Europe and companies in Europe have instead cut back on employing workers due to the weakening economy.  However, a possible breakup seemed to be less of a concern as 2012 drew to a close which was implied by the fact that investors are again buying bonds in countries that were once shunned such as Spain and Italy.  Draghi at the European Central Bank recently pointed to normalization in the finance markets such as bond prices having fallen (resulting in lower interest rates). 

Panic among investors and the resulting higher interest rates had added to the woes of troubled countries in Europe so an easing of stress levels and a return to a focus on economic fundamentals is a crucial step in the rehabilitation of Europe.  However, buyers of bonds can quickly cash out if the situation in Europe turns bad again so this is just the first (but still essential) phase of a recovery in Europe which will take considerably longer.  While anxieties in the markets about the near-term prospects for Europe have abated, the underlying problems in Europe still remain. 

First and foremost are the poor government finances and high levels of public debt.  Many countries in Europe are likely to suffer as their governments cut spending to reign in large deficits.  Even once government revenues and expenditure are back in balance, the actions of governments will be restricted due to a large mountain of debt and this will inhibit the ability of governments to deal with future crises and to invest in essentials such as education and infrastructure for the future.  The previous debt-fuelled boom period which peaked in 2007 resulted in some places in Europe such as Spain and Greece expanding too fast with wages and prices increasing more than what was sustainable.  The global banking crisis in 2008 and 2009 put an end to the excessive borrowing but the high wages and prices remain and require painful changes for these countries to regain competitiveness in the global economy. 

So while frantic headlines of a Eurozone breakup will hopefully be a thing of the past, the legacy of the sovereign debt crisis in Europe will continue in 2013 and beyond.  Sluggish growth is expected for a few years at least and harrowing adjustments in Europe will be required to create the foundations for renewed invigoration of the economy.  Furthermore, the trouble in Europe comes at an inopportune time – the economic rise of countries such as China, India, and Brazil has increased competition for resources and is a challenge to the dominant role of Europe in global affairs.  This places extra urgency for Europe to get back on its feet and Europe’s future role on the world stage depends on whether it can revive its economy or will fall into long-term decline (more on this soon).

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