Don’t Bet Against the Eurozone Just Yet
Posted by hkarner - 13. Januar 2017
The eurozone has managed to muddle through seven years of crisis. It’s likely to do so again in 2017, Simon Nixon writes
No one seems much interested in good economic news from Europe these days. Among investors and policy makers, all the talk is of political risks and how these might reignite the eurozone debt crisis. In British political circles, where the imminent demise of the eurozone has been an article of faith since the moment of its inception, discussion of the eurozone’s political risks have acquired an added dimension of excitement in the wake of the Brexit referendum. Among Brexiters, it is widely assumed that the worse the state of the eurozone, the more willing it will be to compromise with the U.K. in the divorce negotiations.
The logic of this argument is hard to follow and may, in any case, be based upon wishful thinking. Certainly, the political risks facing Europe are real and well-rehearsed. A victory for a populist anti-EU party in any one of the countries facing elections this year—the Netherlands, France, Germany and possibly Italy—would undoubtedly plunge European politics into turmoil.
But notwithstanding the political shocks of 2016, these appear at this stage to be low-probability tail risks. Indeed, the odds of the biggest political risk on the market’s radar screen actually materializing—the prospect of a victory for Marine Le Pen in May’s French presidential election—may even be receding: recent polls suggesting she now faces a three-way fight to reach the second round runoff as momentum builds around the independent centrist Emmanuel Macron, who is campaigning on a market-friendly platform of supply-side reform.
Besides, the evidence from 2016 suggests that economies are resilient to political shocks. The latest economic data suggest the eurozone’s modest but steady recovery that has now been under way for three years may be gaining momentum, driven by higher public and private spending and boosted by an improving global outlook, very low interest rates and a weak euro. The most recent PMI survey of manufacturing output showed the highest reading since May 2011, while the European Commission’s survey of consumer sentiment was at its highest since March 2011.
Unemployment is falling across the eurozone: In Germany, it is now at a post-reunificafion low of 4.1%, while Spain has added 1.6 million new jobs since 2013. French industrial output in the fourth quarter was well ahead of expectations. In Italy, disposable income is rising at its fastest level since 2001. Not surprisingly, many economists are already preparing to raise their 2017 forecasts for eurozone growth and inflation. A stronger economy would reduce some of the political pressures on governments by easing fiscal pressures and improving debt ratios.
Of course, this recovery is weak by historical standards. Most economists are forecasting growth of only around 1.5% this year. More worryingly, even this is above most estimates of the eurozone’s long-term potential growth—the rate at which it can sustainably grow without generating inflation pressures.
That reflects the continent’s weak demographics and poor productivity growth. Without determined measures to boost productivity through supply- side overhauls to education and justice systems and labor and product markets, debt ratios in some Southern European economies will fall only slowly, which means the eurozone will remain vulnerable to shocks. There is no shortage of potential shocks looming, from continuing strains over the Italian banking system, to the standoff over Greece’s bailout, to rising concerns over Portuguese financial stability, to Brexit itself. The path ahead this year could be bumpy.
A second source of economic risk is that a stronger recovery creates asset bubbles or starts to push up eurozone inflation. At the moment, there is little sign of this happening: House prices have been rising sharply in some core eurozone markets, including Amsterdam, parts of Germany and Dublin—but not by enough to alarm central bankers yet.
And while headline inflation in December came in well ahead of market expectations at 1.5%, this was largely due to higher energy prices. Core inflation rose by only 0.1 percentage point to 1%. Even so, any sign that inflation is likely to come back to the ECB’s target of close to but below 2% is bound to increase political opposition to the ECB’s bond-buying program in Northern Europe, where it is blamed for a sharp squeeze on savers’ incomes.
Already this year there is market talk about whether the European Central Bank might decide to further scale back its bond purchases this year, despite having decided only in December to maintain them at €60 billion ($63.5 billion) for the whole of this year. Any sign that the ECB is preparing to taper its quantitative-easing program could create problems for some Southern European governments who currently depend on the ECB’s monetary fire blanket to keep down their borrowing costs. That in turn has allowed them to loosen fiscal policy, which has been crucial to growth.
But for that reason, the ECB is unlikely to yield to pressure to change its policy this year. Indeed, these concerns were a factor behind its decision to extend QE until the end of 2017, beyond the end of this year’s electoral cycle, cushioning the political risks.
The eurozone has so far managed to muddle through seven years of crisis. The best bet must be that it does so again in 2017.