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Muddling through in Europe

Muddling through in Europe
Today’s commentary

The scenario I laid out for Europe for 2014 in three posts on the global eco**my last week*is one of Muddling through. However, whereas in the US, there are upside risks, in Europe the risks are mostly to the downside, politically and eco**mically. A few thoughts on the situation follow.

In my view, the risks are **t just political, but also eco**mic. Right **w there are few positive catalysts that are easily recognizable except for the bottoming process I believe is ongoing. On the other hand there are a number of potential exoge**us shocks that could throw the European eco**my off course.

Here is the macro argument:

• Europe is constrained by the euro, which means that sovereign governments, as currency users, must act pro-cyclically and cut deficits during a deep downturn at the same time all other eco**mic agents are doing so. This makes the European situation more volatile eco**mically, increasing the likelihood of downside scenarios and crisis. The present crisis is emblematic of this risk.
• At the same time, the central bank is constrained by the euro because it is forbidden to facilitate government spending i.e. buy government bonds with the aim of preventing the market-dictated solvency issues of a typical currency user from coming to the fore. Thus, as we have seen during the European sovereign debt crisis, this makes European sovereign debt vulnerable to market sentiment, speculative attack and further reinforces the need for governments to act pro-cyclically.
• Counterbalancing this are European-level funds that can be used to dampen the effects of eco**mic downturns. For example, the EU has recently allocated funds to counteract youth unemployment, which is at a record high in the eurozone, with nearly one-quarter in this demographic cohort out of work. These funds are very limited, however.
• At the same time, even within the periphery, GDP growth has been uneven. Countries like Finland and the Netherlands are actually in recession. France is on the edge. Only countries like Germany and Austria, where unemployment is low and where there has been growth fairly consistently, is there the opportunity to act counter-cyclically to offset the pro-cyclicality elsewhere.
• But, one year later, I still believe Germany concerned about its own public finances (link here).*The Germans don’t like having 80% government debt to GDP and want to get that number lower.*This limits their ability to act counter-cyclically on the fiscal side. Germany has instead boosted domestic demand by easing wage restraint.
• Moreover, thinking in Germany is that easing up **w would send the wrong signal to the periphery. The Schr"oder deficit breach is still rued. Even ECB head Mario Draghi has said that Germany stands as an example for the rest, echoing sentiments widely heard in German policy circles.
• My conclusion then is that the heavy lifting of the eurozone adjustment process will come all on the periphery side.

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Related posts:

1. On the horrendous eco**mic numbers coming out of Europe
2. Why I am relatively upbeat about Europe
3. Risk to the upside in the U.S. contrasts to Europe

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Muddling through in Europe