How Will the Eurozone Cope With the Next Downturn?

Spring brought a burst of sunshine over the eurozone economy. The French economy expanded rapidly in the first quarter of 2015 and even the Italian one managed respectable growth. Fiscal policy is no longer contractionary across the eurozone as a whole. Cheaper oil is boosting consumption. A weaker euro is boosting exports. And the ECB's quantitative easing appears to be working: money supply growth is picking up, suggesting deflationary pressures are easing.
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Spring brought a burst of sunshine over the eurozone economy. The French economy expanded rapidly in the first quarter of 2015 and even the Italian one managed respectable growth. Fiscal policy is no longer contractionary across the eurozone as a whole. Cheaper oil is boosting consumption. A weaker euro is boosting exports. And the ECB's quantitative easing appears to be working: money supply growth is picking up, suggesting deflationary pressures are easing.

But it would be risky for eurozone policy-makers to mistake a modest cyclical upturn after years of stagnation for something more than that. First, business cycles are getting shorter and downturns deeper. The reasons for this are complicated but globalisation and increasingly complex financial linkages between countries appear to be playing a part. Nobody knows how long this eurozone cycle will last but it is probably fair to assume that we are already some way into it.

Second, when the next downturn comes, the eurozone is going to be poorly placed to handle it. There is little to suggest that the current upturn will be strong enough to undo the damage caused by the crisis. Eurozone growth is unlikely to exceed 2 per cent even at the peak of the cycle, with growth in the weaker economies much lower. This will not be enough to render debt sustainable (whether public or private). Given the amount of slack in the eurozone economy, unemployment will remain high and inflation pressures weak. Against this backdrop the ECB is unlikely to raise interest rates, meaning that it will have no room to cut them in an effort to counter the next downturn.

Furthermore, the eurozone has largely failed to address the underlying institutional weaknesses of the currency union. The reforms that have been made basically comprise crisis management tools and rules, whereas the crisis has demonstrated that monetary union without fiscal and financial integration is unstable. Unfortunately, there is little appetite for this integration, especially now that the eurozone is growing. Meanwhile debt burdens continue to grow in the weaker economies and the eurozone governments refuse to acknowledge the need for debt write-downs.

The eurozone needs further fiscal and financial integration to prevent its members from having to pursue precisely the opposite macroeconomic policies to the ones they need. Eurozone countries have given up the safety valve of an independent currency and monetary policy, hence need an even larger shock absorber in the form of fiscal policy.

Not only does the eurozone lack any fiscal transfer mechanism, but the rules of the fiscal compact tightly circumscribe the ability of member-states to impart counter-cyclical fiscal stimulus.

As it stands, the eurozone is a mechanism for divergence among its members, not convergence: real interest rates are highest in the weakest countries, lowest in the strongest. This almost guarantees divergence as capital and the more productive labour become concentrated in the core. This state of affairs persists in currency unions such as the US, the UK or Germany, but the negative effects of it are offset by fiscal transfers between the participating regions or states. The banking union is work in progress: regulation has been federalised but risk not mutualised; banks are still largely back-stopped at national rather than federal level.

What happens regarding Greece will have a bearing on how the eurozone copes with the next downturn. If Greece leaves the eurozone, the ECB might well be able to contain the immediate financial fall-out. But a Greek exit will end the irreversibility of membership. Unless it acts as a catalyst for closer integration, the risk is that the eurozone will come to look like an exchange rate mechanism rather than a currency union. This will increase the likelihood of speculative attacks on the weaker members come the next recession.

The eurozone is all but certain to go into the next downturn with interest rates close to, or at, zero, high levels of public and private sector indebtedness and unemployment still well above pre-crisis levels. The ECB will be able to employ quantitative easing, but its effects will probably be exhausted by then. Critically, there will be little scope for fiscal policy to counter the weakness of private sector demand, especially in the countries most in need of it. And weak banks in struggling countries will essentially still be back-stopped by fiscally constrained governments.

In short, many eurozone governments could face the prospect of further deep recessions despite having barely recovered pre-crisis levels of activity, amid persistently strong support for populist parties. The politics of this is likely to be combustible. At this point it could be make-or-break regarding the bigger institutional questions hanging over the eurozone. It is possible eurozone governments will bite the bullet and agree a fiscal union including a degree of risk mutualisation and transfers between participating economies. But this could prove politically impossible.

The euro is not out of the woods. Eurozone reforms have not abolished the business cycle and the need for counter-cyclical fiscal policy. There is little to suggest that the current upturn will be strong enough to bring down debt levels or enable the ECB to raise interest rates in any meaningful way. But there is much to suggest that the upturn will be used as a justification for further delaying the adoption of the federal structures needed to make the euro a success.