Why 2014 Went Wrong for the Eurozone

2015-01-06

It was supposed to be the year the eurozone exited its debt crisis, when growth would return to the currency union bringing with it confidence and jobs. But 2014 didn’t work out that way. Although the economy emerged from its double-dip recession, likely growth of just 0.8% was even more feeble than the 1.2% forecast at the start of the year, while inflation fell alarmingly close to 0%, raising fresh questions about debt sustainability.

A few former crisis countries, including Spain and Ireland, performed better than expected, but the major economies of Germany, France and Italy performed worse. Hopes of an imminent European Central Bank government-bond-buying program helped drive down borrowing costs for many countries, creating the illusion of calm.

But the eurozone is arguably now in greater peril of breaking up than ever before. The euro fell to its lowest level in nine years against the dollar early Monday amid speculation the ECB will soon expand its stimulus programs aimed at avoiding deflation.

Where did it all go wrong? Three factors in particular stand out. The first was the impact of the slowdown in growth in China and other emerging markets, itself a response to the prospect of tighter global liquidity conditions as the U.S. Federal Reserve ended its own quantitative-easing program. The second was the impact of the Ukraine crisis and the sanctions imposed on Russia, which had a particular impact on the German economy.

These were shocks over which the eurozone had little control and which may continue to exert a drag on growth in 2015, although the impact of weaker emerging-market demand may yet be partially offset by the stimulatory boost from lower oil and commodity prices.

But the third factor in the eurozone’s weak performance in 2014 was homegrown. Structural obstacles continued to impede the rebalancing of many economies, particularly in Southern Europe, preventing capital and labor from being reallocated to where they could be more productively employed. Rigid labor and product markets have made it hard for firms to adapt to the new economic environment and have deterred new investment.

Crucially, weak insolvency regimes and inefficient judicial systems have prevented the restructuring of private-sector debts, essential to enable banks to work through their vast portfolios of nonperforming loans. Meanwhile, high levels of taxes, corruption, bureaucracy and protection for vested interests continue to discourage the supply of the new equity capital that the eurozone urgently needs to fund a new cycle of growth.

Removing these structural obstacles is crucial not only for the eurozone’s growth but also for its long-term viability–a point made by ECB President Mario Draghi in a recent speech. In a currency union that lacks automatic fiscal transfers, member states that lack the capacity to swiftly and efficiently rebalance their economy are less able to absorb shocks.

Yet the scale of reform required in some countries to enable this rebalancing amounts to a cultural revolution, a Reformation akin to the campaign to sweep away the corruption and abuses of the medieval Catholic church. What became clear in 2014 is that achieving this Reformation is proving harder than many had anticipated.

Clear signs of reform fatigue have emerged in Spain, Portugal and Greece, while in France and Italy, even relatively modest reform programs were watered down in the face of powerful opposition.

Why is reform proving so hard?

Of course, much of the problem lies with weak political structures: Even determined governments have struggled to contend with well-organized and well-funded interest groups embedded in bureaucracies, trade unions, judicial systems and the corporate sector. But a crucial factor has been the political context in which reformers have had to operate. The eurozone is increasingly paralyzed by a sterile debate focused on a supposed conflict between “austerity” and “growth.”

Those who argue that the eurozone’s core problems are structural are confronted by a simplistic Keynesian analysis that holds the eurozone’s real problem is a lack of fiscal and monetary stimulus, that its challenges are macro rather than micro, reflecting lack of demand rather than impediments to supply. Policies to eliminate wasteful spending, improve efficiency, enhance productivity and boost potential growth are dismissed as growth-sapping austerity.

The antiausterity banner has become a rallying point for resistance to all reform, reducing the political space for governments to tackle structural problems. Support for radical leftist parties is being fueled by the naive belief that if only Germany would repair its bridges or the eurozone would build more roads or the ECB would embark on quantitative easing then governments would have no need for spending cuts or reforms.

It is this deepening ideological divide which now threatens to rip the eurozone apart.

Never mind that few economists expect quantitative easing to deliver significant benefits in the highly indebted, bank-dominated eurozone; or that the spillover from any German public-spending program to Italy and France is likely to be meager; or that the same structural problems that impede domestic investment also make it hard for the European Union to identify and deliver growth-friendly projects.

Never mind also that a collapse in fiscal discipline risks undermining not only market confidence but also the trust between governments vital to future integration. And never mind the warnings of Mr. Draghi and others that stimulus without reform will harm rather than help the eurozone. Faith in Keynesian magic bullets is impervious to such concerns.

This ideological clash may yet come to a head in 2015. The first flash point is in Greece, where a snap election will be held on Jan. 25 following Parliament’s failure to agree on a new president.

In reality, the risk from Greece may be overstated, given the weakness of the country’s political and financial position and the radical-leftist opposition party Syriza’s commitment to keep Greece in the eurozone. But potentially more troubling threats to stability may emerge elsewhere. Weak governments in France and Italy may not be able to withstand the ideological tide. Elections later in the year may bring antiausterity parties into government in Spain and Portugal.

Policy makers may try to buy off this counterreformation by acceding to demands for extra stimulus, but all they can buy is time. The eurozone has no capacity to force member states to embrace the path of virtuous reform–even when its own survival is at stake. That remains its central weakness.

Source from : Dow Jones

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