Eurozone economies could be heading for more trouble

EUROPEAN monetary authorities appeared to have a pretty clear vision until February 2014 about the likely outcome over the next few months - banks would clean up their balance sheets and governments would begin to stabilise, and possibly cut, their debts as growth gathered momentum, writes Professor Enrico Colombatto. At this point, the European Central Bank (ECB) would announce that the financial crisis was over, recovery underway, and it was time to reduce the amount of liquidity in circulation to allay the credit crunch. Sadly, something went awry. Growth is low and ‘fragile’. Unemployment is high, especially among young people. Some banks have begun extensive clean-ups, but many credits are likely to become losses if the business climate does not improve. The public-finance situation of several euro-countries has continued to deteriorate and is more vulnerable to the cost of debt-servicing, which depends on the rate of interest. Financial markets have received two messages from the ECB the European Commission in this not overly-encouraging environment. First, the ECB is considering further reductions in key interest rates to encourage commercial banks to use their liquidity to finance producers and entrepreneurs. Second, EU authorities have emphasised that regulatory compliance and fiscal discipline will be enforced. A new chapter in European Union economic history may be opening up. Europe’s monetary policy strategy over the past years could, perhaps, be justified as an extraordinary attempt to ease adjustment in a number of key countries. But another two years of low interest rates could generate new problems. It is now apparent that low interest rates have helped large EU countries such as Italy and Spain avoid default, but they have failed to prevent the size of the public sector and taxation from increasing. French government spending, for example, is currently about 57 per cent of gross domestic product (GDP) and likely to reach 60 per cent soon. The French debt-to-GDP ratio will be beyond 95 per cent by the end of 2014. Most economists concede the government sector is choking opportunities of growth or reducing unemployment. A second problem relates to the business environment. Small firms will still find it hard to obtain easy credit as in the recent past. Regulators insist on forcing banks to keep very low risk profiles. This means the banks are more willing to finance governments and large corporations, which are regarded with less suspicion than small business. A third issue relates to consumers. High taxes, reduced pensions and rampant unemployment have put many households under pressure in several European countries. Incomes are barely enough to support consumption and savings have become negative as individuals use their assets or borrow using consumer credit. Low interest rates make consumer credit particularly tempting for the borrower and to the lender. If savings are driven down by low interest rates, and investments in new machinery and equipment depend on savings - minus those diverted to finance public debts - how can one hope to revive growth? The scenarios that these problematic situations suggest are far from encouraging. The sudden turnaround of the Bundesbank, Germany’s central bank, to back the ECB’s stimulus measures, does not bode well. Do European authorities favour an ‘aggressive’ monetary policy with negative interest rates on deposits and more quantitative easing because they have confidential information they do not want to disclose? Have they decided to forget about sound money and hope that inflation will sooner or later reduce the real value of public debt in key countries? We see two possible patterns unfolding during the next few months. One assumes that the recovery in the eurozone is underway, although slower than predicted, and that the European monetary authorities are in control. Low interest rates should be seen as some kind of precautionary measure, under these circumstances, in order to prevent a fragile recovery from stalling. If this is the case, timing will be crucial, as growth can hardly be sustainable if structural reforms are not carried out. A gloomier perspective would be one where the EU authorities are not in control, but have made their choices. Given that key countries are in trouble with low growth, high unemployment, and worsening public-finance conditions, and that the EU cannot afford a new crisis, the long-term goals are being put aside. Instead, all policy fire-power is directed at making debt-servicing easy and weakening the euro to boost the competitiveness of EU businesses on world markets. The cost to EU citizens could be high with over-indebted households, low private investments, and not enough new firms. Sweeping the problems under the rug in this way will make room for new tensions before long.

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