Europe – finding a way out

Europe seems trapped with a sluggish economy but a way out may be close

Getting out of a hole that you have dug for yourself can be tough.  This is what Europe is struggling with as the Eurozone crisis seems to have passed only to be replaced with a slow strangling at the hands of deflation.  Infighting among politicians about the best way to deal with the economic stagnation in Europe has resulted in few reasons for hope of an escape.  Yet, this may change due to recent developments such as a flagging German economy and the rise of reform-minded governments in some countries.  Sometimes things need to get worse before a way out is possible and the situation in Europe may have finally got bad enough for positive change to occur.

An economic escape route…

An economic recovery is typically an automatic progress but may not always be easy.  Companies going bankrupt and workers losing their jobs cause considerable pain but is actually something that is good for the overall health of the economy.  A cull of weaker businesses provides more space for more successful firms to grow and prosper.  This process has the label of “creative destruction” in economic theory due to the idea of the old needing to give way for the new. 

In this way, economic growth returns after a recession as resources such as workers move to more productive uses.  The economy can grow faster as a result but a certain level of economic freedoms are needed to allow this to happen.  In this way, there is a trade-off between economic growth and the potential for instability.  It is not possible to have the former without the latter but any instability can be limited through controlling economic excesses (which often show up in the financial system).

Getting the balance right is not easy.  Companies in finance have been given too much leeway and created havoc as a result.  Yet, in other areas, businesses have been burdened with too many rules.  One example is regulation which makes it difficult for firms to fire workers.  This may seem like a good way of keeping people in jobs but such regulation has an adverse effect in that companies will not want to take on new workers if their employment is almost permanent.

… and the politics to make it happen

Many countries in Europe are in desperate need of policies to free up business from such regulation but implementation is often tricky.  At a time of rapid change, voters often crave stability of bygone eras that are no longer viable.  This does not stop populist parties making false promises to turn back time and dismissing the need for reforms.  It is heartening for the outlook in Europe that some countries such as Spain have made progress with its reforms.  Others such as France and Italy also have governments that are making the right noises in terms of reforms even if not actually putting new policies in place.

The lack of reforms has been preventing the recovery in Europe in other ways.  Germany, who has a firm grip on the reins of power in Europe, has stubbornly refused to offer much help to struggling European countries.  The reasoning behind this is that offering an easy way out would mean that these countries would not deal with the problems within their own economies.  The flip side is that, once reforms begin, Germany may be more accommodating in providing support. 

This opens up the possibility of a grand bargain, such as reforms as a trade for looser monetary policy and less focus on austerity.  More action from the central bank seems likely as the German economy is beginning to falter and genuine fears about deflation in Europe grow.  Its own weak economic growth and low inflation will highlight to the Germans that the problems are plaguing Europe as a whole rather than just individual problem countries.

Your Neighbourhood Economist penned this posting with comments from readers in mind.  Europe and the euro was seen as a lost cause by one reader while others have been annoyed that this blog always had to be so pessimistic.  Hopefully, this post will hopefully prove them wrong (but in a good way).

Eurozone crisis: Still bubbling away

The debt crisis in Europe seems a long time ago but a political hiccup in Italy shows that its revival may not be that far off.

Around this time last year, weeks would go by without this blog commenting on anything but the Eurozone crisis.  The turning point came near the end of 2012 with a bit of imaginative policy making by the European Central Banks who said they were willing to do “whatever it takes” to save the euro.  By the start of 2013, the worst seemed to be over (Good and Bad in 2013), but many of the problems still had to be fixed.  This year has seen the economic problems in Europe simmering away in the background rather than being likely to erupt as in 2012.  However, the turmoil in Italy at the moment shows that it does not take much for things to heat up again.  Europe may not dominate the headlines as in the recent past but it is never too far from the front pages and here is a look into why.

Politics in Italy are tricky at the best of times but an election earlier this year left the country with a fragile coalition.  A fresh saga was triggered as the constant distraction that is Silvio Berlusconi looked to pull his support from the government after being convicted of tax fraud in August.  Yet it was Berlusconi who suffered from his latest attempt at meddling as he was forced into a dramatic U-turn which involved providing support to the government in order to avoid seeing his own party rebel against him.  After a jump in the interest rate on Italian government bonds, the weakening of Berlusconi cheered investors as he had held sway over Italian politics for a long time despite Italy having not benefited much from his time in power.

Although Italy has avoided the unwelcome prospect of another round of elections, the problems that the country faces are greater than the immediate political woes (for some background, see Bigger than Berlusconi).  This year, the government budget deficit is expected to top 3%, which is the upper limit for EU countries, with government debt approaching 130% of GDP.  The coalition government lacks the political capital to push through the necessary reforms to get the economy moving ahead to help generate the tax revenues needed to reduce the shortfall in the government’s finances.

Italy is hampered by a problem which is typical for countries in Europe feeling the strain in the aftermath of the Eurozone crisis – voters weary of austerity measures with little to show for their perseverance.  Mainstream political parties who have been pushing government cuts have seen their support eroded by fringe parties which promise relief through policies which will have negative long term effects.  The democratic process has struggled to deal with the consequences of the economic slump and mounting debts following the global financial crisis.  Voters have been stuck with two unappetizing options – enduring the hardship of austerity with scant rewards or repelling against spending restrictions but becoming an outcast in the financial system.

The same themes can be seen being played out in Portugal and Greece among others.  Greece has witnessed the rise of the far-right extremist Golden Dawn party which has fed off the frustration of Greek voters.  Local elections in Portugal resulted in heavy losses for the ruling party who had pushed through austerity measures.  Despite all the hardship endured in these two countries, further bailouts are seen as necessary to deal with the stubbornly high levels of government debt.  The economic stagnation in Europe continues with countries like Greece still suffering with GDP down by 6.4% in 2013.  Portugal, Italy, and Spain among others also ended 2012 with lower GDP. 

While the European Central Bank has staved off the immediate threat of crisis, the flipside is that the pressure for reforms has eased.  As such, politicians can no longer blame the financial markets for their unpopular policies.  Leadership in Europe has also been lacking with the national elections in Germany drawing the attention of Angela Merkel away from Europe.  Coalition negotiations in Germany following the elections in September will leave Europe seemingly leaderless for a few more months.  The Eurozone crisis may have been put on the back burner but it could still boil over at any point if not watched.

Bigger than Berlusconi

Up until now the crisis in Europe has involved plenty of Greece, large doses of Portugal and Ireland and a dash of Spain.  But seemingly from nowhere, Italy hit the headlines last week and took the unenvious position of centre stage.  The new focus on Italy changes the extent of the crisis. Greece makes up a mere 2.5% of GDP in the euro zone and Germany’s economy alone is more than 10 times larger.  On the other hand, Italy’s GDP is over 16% of the euro zone, and with government debt approaching 120% of GDP, any help for Italy is going to involve a considerable amount of funds.

A lot of fingers have been pointing at Silvio Berlusconi, the ex-Italian Prime Minister who resigned over the weekend, but Berlusconi was a symptom of a larger problem in Italy.  Italy is a country that is dominated by a range of different interest groups (be they unions, public sector workers, pensioners, Northerners, and so on) which makes the country difficult to govern (as any change to government policy is likely to annoy some group in society).  Berlusconi has made this worse by his own aversion to reform.   The lack of leadership and the control of the interest groups has dulled the dynamism of the economy and saddled Italy with its large debts.  One result of this is a lot of cumbersome regulations, which has Italy ranked 87^th in the World Bank’s ease of doing business ranking (just below Mongolia).

As such, the economy in Italy has languished and others boomed.  Between 2000 and 2008, Italy grew at an average annual rate of 0.8%, the lowest in the Eurozone, compared to the Eurozone average of 1.8% and 3.8% in Greece.  Greece’s problems stemmed from too much debt at low interest rates after having joined the euro fuelling growth that was unsustainable.   But, in Italy, a stagnated economy meant the country missed out on the party in the good years but is still suffering from a hangover. 

Slow growth by itself would not have been a problem had it not been coupled with high levels of debt.  Unlike Greece, government debt has typically been high in Italy and has not been seen as a problem until Greece brought it to the forefront of investors’ minds.  Berlusconi has helped to make the situation worse by backing away from plans to rein in government spending and this is what ultimately prompted already jittery investors to sell off Italian government bonds and cost Berlusconi his job as Prime Minister.

While Berlusconi himself is not the main problem, removing him from power may open up the door to a solution.  But it depends on the governing powers in Italy being bold enough to put in place policies that will not only bring down its debt but also free up its economy and also on voters that recognize that this is necessary.  The markets seemed to have helped highlight the need for change and I think that this will put Italy back on track.