Crisis eases, but Europe’s not yet out of the woods

Recession grips the eurozone. The economy of the 17-nation bloc contracted by 0.6pc over the fourth quarter of 2012, we learnt last week, a much worse result than expected and the third consecutive quarter of real GDP decline.

The worst performers were the Portuguese, Italian and Spanish economies, which shrunk by 1.8pc, 0.9pc and 0.7pc respectively compared to the previous three months. But “core” members also dragged on the currency union’s performance, with national income falling in France, Austria and the Netherlands too. Even Germany stumbled, the region’s economic powerhouse losing a shocking 0.6pc of GDP between October and December.

During 2012 as a whole, it appears that the eurozone, an economy roughly the same size as that of the United States, contracted by 0.5pc. This represents the single currency area’s first full-year contraction since the sub-prime meltdown in 2008. Little wonder, then, that this bad eurozone news dented investor optimism towards the end of last week, tempering the recent rally in global stocks.

These latest data are “flash estimates”, without a detailed breakdown. Germany’s official statistical agency made clear, though, that its GDP contraction was caused by sluggish investment in plant and machinery, as businesses continued to worry about the impact of the region’s on-going sovereign debt crisis on broader demand. While that sounds highly plausible, a vocal branch of opinion insists that these latest GDP numbers represent the trough of the Eurozone’s recession, and that we’re on for recovery in 2013. I hope that’s true, but am very far from certain.

Bond yields clearly suggest that market anxieties about one or more countries being forced to leave the eurozone have eased in recent months. This follows incremental assurances from European Central Bank President Mario Draghi that he would do “all that it takes” to keep the currency bloc in its current form.

Since Draghi made those commitments over the course of last summer, the ECB has further under-written the liabilities of various financial institutions and governments, overtly and otherwise, shoving yet more private sector losses onto the shoulders of the broader population. Germany, meanwhile, has turned a blind eye, moaning about “debt monetization” but allowing, nevertheless, the ECB to join the “advanced” Anglo-Saxon economies in ramping-up its balance sheet at an unprecedented rate.

For now, the confidence trick is working. Italian and Spanish sovereign yields have eased, their ten-year bonds trading some 250 basis points lower since Super Mario’s efforts. But while we’ve seen some respite on global markets, concerns about a euro-induced “Minsky moment” have been replaced with a growing realization of the long-term structural challenges faced by many eurozone members, not just the “periphery”, but also the larger economies.

Recovery will stem from export growth, the eurozone bulls counter, fuelled by improving competitiveness. On the surface, exports from the single currency area are recovering. During 2012, the region registered a €818bn trade surplus, a marked improvement on the €16bn deficit of the year before, suggesting an export-led recovery could be around the corner.

Having said that, eurozone exports have been trending downwards since the middle of last year. What drove the 2012 surplus wasn’t export strength but the fact that the region’s imports fell even faster. So the eurozone’s eye-catching annual trade surplus is actually an illustration of the weakness of domestic demand.

The other fly in the export ointment, according to some at least, is the currency. As investors have succumbed to Draghi’s dulcet tones, allowing themselves to be convinced that the eurozone’s systemic crisis has been contained, so the currency has risen, making exports more expensive. In real effective terms, allowing for changing price levels and against a currency basket representing the region’s main trading partners, the euro has appreciated by 3.9pc since last August. In a world of super-thin margins, this can indeed have a negative commercial impact.

When the latest eurozone GDP numbers were published, some European investors took solace in the fact that the corresponding Japanese data, released on the same day, showed a 0.4pc GDP decline in the fourth quarter. Because the eurozone is contracting faster than Japan, the argument goes, the ECB could justify taking more “drastic” action than even a newly emboldened Japanese central bank, printing money faster, so causing the euro to fall against the yen.

Yesterday, the G20 group of industrialized and emerging nations, meeting in Moscow for the first time, issued a carefully negotiated communiqué declaring that there would be no “currency wars”. The very fact, though, that Japan’s recent yen-weakening antics escaped official censure means that efforts to competitively depreciate currencies – in Japan, the US, the UK and the eurozone too – are now more likely to continue than ever.

The yen has dropped from 80 to almost 94 against the dollar in the last two months, a fall that other countries are eyeing jealously. Yet to urge the ECB to follow suit and debase the currency by printing more money, as most eurozone members now advocate, strikes me as a counsel of despair. The “strong euro” is anyway a red herring. On a real effective exchange rate basis, the single currency was 5.4pc weaker on average during 2012 than it was the previous year. Still, it’s a lot easier for Western politicians to blame “foreigners” for our commercial failings and woeful economic performance that it is to explain and then implement the kind of structural reforms needed to boost productivity and genuine economic competitiveness.

While the immediate danger of a systemic eurozone crisis has undoubtedly receded in recent months, it would be foolhardy to say it has disappeared forever. For one thing, the longer the region fails to grow, the worse its fiscal balances will look, and the higher the chances of a bond-market rebellion. More fundamentally, it remains the case that in the long run it is simply impossible to maintain a fixed exchange rate among democratic countries with different social systems and different political traditions, to say nothing of wildly diverging productivity growth rates. This remains, I’m afraid, the inconvenient truth.

Last week, the House of Lords European Union Committee made a significant but little-noticed intervention, writing a public letter to the Treasury “warning against a growing complacency among EU leaders that the euro area crisis has been resolved”.

In a document that was deeply critical of economic policy in both the eurozone and the UK, the committee pointed to a “significant backtracking” on the June 2012 agreement of the European Council to break the tortuous financial links between sovereign states and banks. This “runs the risk”, the committee wrote, “of a repeat of the 2008 financial crisis”.

Their Lordships warned that “the deal on eurozone banking union [secured in December 2012] may not prove as water-tight as the [UK] government believes”. The EU committee also judged that the ECB’s bond-buying commitments “may simply be masking the underlying difficulties facing many euro area countries”, while warning the British government against “seeing the euro area’s woes as someone else’s problem”, not least as “the implications for the UK are immense, not only economically but also in terms of political ramifications”.

So recession still grips the eurozone. We must all hope for a swift recovery, that currency union members can enact the structural reforms so desperately needed and that fully-blown currency wars, and the self-inflicting damage of explicit competitive devaluations, can be averted. Yes, the UK economy, which shrunk by 0.3pc in the fourth quarter is faring slightly better than the eurozone, for now. But this is no time to gloat.


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