Perspectives

Europe: drifting apart

Published: Mar 2015

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As investors demonstrate unwillingness to finance the social spending of weaker performing Economic and Monetary Union (EMU) countries, those countries who have performed comparatively well and successfully managed their debt deficits are worried they will be left to foot the bill. This article explores the options available and their implications for both strong and weak EMU countries.

The rising status of populist parties in Europe is threatening the Economic and Monetary Union (EMU). Those parties’ demands for more fiscal stimulus and less extensive structural reform measures appeal to many voters who are accustomed to costly social provisions and protection. Whilst such provisions may be socially desirable, they are also very expensive and divert increasing amounts of money away from projects that enhance both competitiveness and the earning capacity of the economy.

Most European countries need to borrow money to finance social spending on a structural basis. Earning capacity, meanwhile, has slowly but surely deteriorated and debts have been piling up. The Eurozone crisis signalled that investors were no longer willing to finance social spending of many weaker EMU countries due to concerns that some countries would not be able to pay back their debts.

An appropriate way to respond to rising concerns is through structural reforms that increase earning capacity and make economies more competitive. This, however, is easier said than done. It would require less spending on the social system (a short-term pain) to free up money for productive investments (a long-term gain) and offer less protection of influential political stake holders because of initial lack of appeal. Most politicians, who campaign for a four year term in office, fail to convince voters of the need to make sacrifices in order to strengthen the economy in the longer term.

Instead, more and more voters are turning to populist parties who promise less painful structural reforms and, instead, more debt-financed government spending.

Structural change is crucial

Without structural reforms, credit going into the private sector is bound to stagnate. Already, growth across Europe is sluggish and unemployment is high. Therefore, wages have not been rising enough or sometimes not at all. The only way to quickly boost demand is through wider budget deficits. Germany, however, fears that the politicians in the weaker Eurozone countries will make use of any fiscal stimulus measures to postpone the necessary structural reforms. The experiences with Greece are proving the point. The German government is especially dissatisfied that Paris immediately declared its sympathy for the Greek desire to pursue a less stringent budget policy after Syriza won the Greek elections.

Chart 1: Weak labour market and poor credit activity in the EMU creates a downward pressure on inflation

Chart 1: Weak labour market and poor credit activity in the EMU creates a downward pressure on inflation

Source: Thomson Reuters Datastream/ECR

Pivotal in this situation is the European Central Bank (ECB), which can bolster credit supply in the private sector via lower interest rates, more money creation and, if need be, higher asset prices. However, the same proviso applies. As the central bank becomes more active, fewer reforms may be implemented. Since the credit crisis, for example, most member states have not implemented as many structural reforms as they intended and/or promised. This has contributed to the fact that, despite looser monetary policy by the ECB, credit has eased far less than anticipated.

ECB action necessary but will it help?

Given the circumstances, it is undeniable that the weak Eurozone countries are struggling because demand is lower than supply. Widening budget deficits do not offer real solutions (although many governments see this as an essential first step). That is, negative deflationary spirals loom in these member states and, unless something is done, this could lead to a deeply embedded economic crisis. The ECB, therefore, has intervened and announced a large-scale bond-buying programme, in combination with money creation.

Apart from the question whether such a policy will exacerbate the debt problem whilst structural reforms are not forthcoming, the expectation is that ECB’s bond-buying programme will do little to facilitate credit supply. Yes, the value of potential collateral will appreciate but earning capacity will not increase.

Chart 2: Social costs for Spain and the other weaker EMU countries have been enormous

Chart 2: Social costs for Spain and the other weaker EMU countries have been enormous

Source: Thomson Reuters Datastream/ECR

In addition, private individuals in Europe (in contrast with the US) own relatively few shares and bonds. Many people are home-owners and consider property price rallies far more important. The problem, therefore, is that most European governments are pursuing policies that aim to prevent the type of housing bubble that triggered the recent credit crisis rather than focusing on those to increase credit supply.

As credit continues to be tight, growth will remain sluggish, and budget deficits will tend to widen. It is a concern that the need to reduce deficits will act as a drag on the economy, potentially slowing down growth further and resulting in deflation looming for longer. Such concerns are prompting governments to ask Brussels for permission to widen their budget deficits.

Germany becoming isolated

When it comes to the issues discussed in this article, all of the participating member states in the EU have equal voting rights. Only a few countries within Europe, however, have an economy that is performing reasonably well – first and foremost Germany. Whilst many of the weaker EMU countries find it very hard to implement structural reform, at the present juncture, the stronger ones are boxed into a corner:

  • Increasingly, the stronger performing member states find themselves in an isolated position. Germany, for example, thinks that the problem countries should be implementing structural reforms quickly but the debt-laden states are turning the tables on Berlin. They, in contrast, think the ‘well-off’ countries should apply fiscal stimulus in order to help the weaker Eurozone economies. Additionally, they want the EMU to drop the requirement that deficit reduction should be of top priority for them, eliminating its sluggish effect on the economy.

  • The governments of the weaker Eurozone countries think Berlin is not considering the social misery in their countries that result from the deteriorating economic conditions. It is in this context that they point to rising popularity of populism that could be damaging. On the other hand, the strong member states can see storm clouds gathering. Unless earning capacity improves swiftly, it will only become harder for those under-performing Eurozone countries to pay off their outstanding debts. Eventually, this could spell financial disaster – particularly in combination with an ageing population, which will be demanding on public finances. Gigantic losses could be on the horizon and the countries with stronger performing economies fear that it will be their taxpayers that have to foot most of the bill.

  • Stronger EMU countries, however, are frequently overruled within the ECB. The weaker Eurozone countries are shouting down the stronger member states. This is why the central bank recently decided to launch a large-scale bond-buying programme even though Germany and the Netherlands, among others, were opposed. It is no surprise that EU membership and management is a contentious political issue.

  • In the case of Germany, another factor is also relevant. When the country decided to adopt the euro in 2002, it did so based on a guarantee that budget deficits would remain modest and that high inflation would be out of the question. But now, the deficits threaten to widen too far and the current ECB policy could well be too accommodative in Germany’s eyes. As Germany is the only European country with full employment (give or take), however, it could benefit from tighter monetary policy.

In conclusion, it seems that further Eurozone tensions may well be on the cards and in all likelihood, this will have a huge impact on the financial markets. And whilst quantitative easing (QE) by the ECB could send asset prices higher (at least for a while), it will do little to boost economic growth. If advocates of widening budget deficits become more vocal, this is bound to frustrate the stronger EMU countries, which fear that they will have to foot the bill if everything goes wrong.

In other words, although we expect a Grexit will be avoided this year, we do expect the continuation of rising tensions between the weaker and the stronger EMU countries. Such tensions will weaken the euro further and invigorate the battle we expect in interest rate markets in the weaker EMU-countries. QE by the ECB will exert a strong downward pressure on interest rates, whilst rising tensions mean a strong upward pressure. Only time will tell which force will win.

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