Europe: Is There a Light at the End of the Tunnel?
Thanks to the actions taken by the European Central Bank (ECB) in 2012, the euro crisis is over. But the damage inflicted to the real economy will take years to repair. Indeed, in the absence of a more robust recovery Europe could experience a decade of low growth, low inflation, and high unemployment and stubbornly high private and public debt levels. Many commentators see the danger of Europe facing a lost decade. Whether the economies of so-called periphery member countries will be able to converge with the core under such circumstances is very much an open question.
In order to avoid such a bleak outcome, European political leaders are trying to recalibrate their policy mix. So far their dual strategy was based on fiscal discipline on the one hand—aimed at reducing high public debt levels and restoring market confidence in the ability of euro zone member states to service their public debts—and, on the other hand, a series of structural reforms that should make weaker economies more competitive and help to spur growth. In euro-speak this strategy is commonly known as growth-friendly fiscal consolidation.
However, while most euro zone governments are still trying to reduce fiscal deficits—some more successfully than others—overall debt levels are still growing. In some of the larger countries, such as France, the most pressing challenges, including the need to reduce the very high level of government spending and to overhaul an overly rigid labor market, are not yet being tackled. Partly as a result of timid reforms and the growing uncertainty in some of the key European countries, the recovery in most euro zone countries is still very weak and fragile. Its economy is still 2.7 percent smaller than it was before the financial crisis erupted in 2008. European policymakers realize that only more robust economic growth will ultimately allow for a significant reduction of the continent’s significant debt overhang.
Given unacceptably high levels of unemployment and the fact that some of the stronger euro zone economies are now finally suffering from the prolonged slump in the periphery, creating the conditions for a more speedy and robust recovery has become the most pressing priority. Policymakers in Brussels and European member state capitals realize that the inability to overcome the crisis is extolling growing costs, not only in economic but also in political terms.
The good showing of radical parties in the recent European Parliament elections suggests that many voters across Europe are simply losing faith in the capacity of their political leaders and European institutions to put the continent back on track.
As a result the focus of the European debate is shifting from an emphasis on debt reduction to one more focused on fostering growth-enhancing measures. In June, the European Central Bank announced a new package of measures aimed at easing the credit constraints confronting the job-creating small and medium-sized enterprises in most euro area countries. If the situation does not improve and downward pressure on inflation does not subside, the ECB has declared that is even prepared to intervene in capital markets directly with the outright purchases of assets. In other words, the ECB is prepared to emulate the Fed’s approach and launch its own, modified, version of Quantitative Easing. Even the hawkish German central bank, the Bundesbank, supported the latest decisions made by the ECB’s Governing Council. Against this background, some media reports suggesting a new split between southern European countries that advocate a relaxation of the fiscal straightjackets and the core maintaining that everybody should simply stick to the rules are grossly exaggerated.
Indeed, both Germany and its weaker European partners realize that a dramatic departure from the commitments made in the past few years on the need for fiscal consolidation would be a grave mistake, not least because it could scare markets and undermine efforts to regain some fiscal “breathing space.” Surely, the commitment by the ECB to do “whatever it takes” to preserve the common currency has the power to deter investors from betting against the euro itself. But if markets start having doubts about the commitment by European governments to tackle their debt overhang, pressure on individual government bonds could make a comeback, causing yields to rise, thereby leading to rising costs for some national governments.
When Europeans—mostly in the periphery of the continent—advocate a relaxation of the rules contained in the growth and stability pact, what they mean therefore is no dramatic departure from previous commitments but, rather, the need for the rules to be interpreted with some degree of flexibility. Italy’s Prime Minister Matteo Renzi, one of the most vocal supporters of a more pragmatic approach to fiscal consolidation, has in fact promised that he has no intention of abandoning the path of fiscal rectitude and will stick to EU budgetary rules. Italy’s fiscal deficits will not cross the 3 percent threshold, the limit contained in the stability pact, he said. What Renzi is asking for is merely more time to reduce Italy’s public debt, which, due to the sharp reduction in economic activity in recent years, instead of shrinking has reached new record high levels.
Italy’s prime minister can only obtain some marginal maneuvering room. Europe is not about to initiate a grand scale debt-funded stimulus package.
Not surprisingly, the reaction in Berlin suggests that Chancellor Angela Merkel is willing to give the young prime minister the benefit of the doubt. The grand coalition in Berlin will allow for a more flexible interpretation of the fiscal rules as long as member countries implement an ambitious reform agenda. Spain and France’s governments support Renzi, perhaps hoping for more. However, Paris is in a different situation. Unlike Italy, France’s budget deficit is still nowhere near the 3 percent limit and Paris as well as Madrid have already been granted more time by the Commission in Brussels to reduce public spending. Furthermore, unlike Spain, which has already implemented some significant reforms of the banking sector and labor market, and Italy, where the debate about the need to implement a series of institutional and economic reforms could also lead to some changes, the French government has taken a wait and see approach. It is still unclear whether the recent cabinet reshuffle in Paris will be able to change that.
Indeed, the current European debate about the speed of fiscal consolidation should be a welcome opportunity for Merkel to once again push for a series of competitiveness pacts between member states and the EU Commission. Merkel failed to push for such binding commitments in the past and had to temporarily abandon the project in late 2013. She now has a chance to link her support for an increase in fiscal maneuvering room to the implementation of more decisive structural reforms. Indeed, the German government should currently be less worried about Rome’s government—which at least is openly pushing a reform agenda for the country— and more preoccupied with the chronic stasis in Paris.
Which brings us to the agenda for the next commission in Brussels under its newly elected/appointed president Jean-Claude Juncker. How far reaching the impact of the controversial selection process of Juncker will be for the institutional balance of the EU is not yet clear. So far the fact that Juncker was chosen by the EU Parliament has merely confirmed that the representative body is gaining ground and that the Council—made up of heads of state and government—is still the most powerful European body.
Not surprisingly, the German finance minister Wolfgang Schäuble, an ardent supporter of close European integration, appears to be very pleased about how things panned out. At a recent AICGS symposium in Frankfurt he recalled that in his many conversations with his British counterpart George Osborne, he reminded the Chancellor of the Exchequer of his own British history. Over centuries, in the contests for supremacy between king and parliament it was “usually the king that lost those fights. This is how democracies work.” Schäuble did not elaborate on the Englishman’s reaction to his words.
Both Parliament and the Council will in fact claim some control over the new Commission. The Council—which is the second chamber in the EU institutional architecture—will try to impose a “governing agenda” on the new Commission. As a result the Commission could either end up being squeezed between Parliament and Council, relegated to the role of a mere enforcer, or it could use its central position between various institutions in order to build bridges between Parliament and Council and between EU member states of the north and south. In the process the Commission could even gain more democratic legitimacy and some political independence. Juncker could surprise doubters and make a big difference, but this will largely depend on the willingness of Europe’s biggest stakeholders to tolerate such an outcome.
One of the more pressing issues that Juncker faces is to build a bridge to London in order to avoid a British secession from the union. It will not be an easy task. If the British prime minister is wise, he will abandon the ideological and personal opposition to Juncker and embrace a more pragmatic approach in order to extract real concessions from Brussels. If he succeeds he would be able to claim to British voters that he not only stood on principle in rejecting Juncker on a personal level, but also that he eventually got from Juncker’s EU most of what he asked for on substance.
Under the circumstances, it was probably wise for David Cameron not to clearly define what exactly that substance is. This will allow him to gain some additional tactical maneuvering room. Ultimately the prime minister needs a powerful sales pitch for British voters rather than the implementation of a detailed agenda. The right narrative will trump anything else. Some tension and repeated clashes at the negotiating table are to be expected. They will be part of the story. But it would be foolish for EU partners to completely marginalize Cameron and the UK in the long run as it would prove to be self-defeating for the prime minister to push himself into a tight corner. In such a scenario, British voters could be tempted to vote for the original euro skeptics even in a national contest, pushing the conservatives out of power and the UK out of Europe.
The rift between the British government and the rest of Europe can still end up being a storm in a teacup, but only if it is carefully calibrated. In the end it could even prove to be useful in order to bind the restless Brits to a deepening Europe on one hand and allow for some repatriation of EU powers back to member states on the other. It may sound like squaring the circle. But these things are possible and many Europeans—Germans included—would support such a course of action wholeheartedly.
Even those Europeans who see the need for closer integration, especially for the euro zone, realize that will have to strike a new balance between nation states and community institutions if they want to convince a growing number of skeptics at home. Indeed, the real negotiations about the future of Europe and the British place within it are only about to start. What we heard lately was only loud noise amplified by the harshness of the financial and economic crisis in Europe. National politicians in many countries have conveniently allowed the EU to become the easy scapegoat for everything that is wrong with the continent, and the standing of EU institutions has suffered as a consequence. The next few years will determine whether it will be possible to get the genie back into the bottle. The euro zone in particular has proven that it can withstand an economic shock. Whether it can survive a prolonged, decade-long slump, is an entirely different matter. National governments as well as EU institutions have to tread very carefully in the coming years if they want to preserve the impressive achievements of the past decades.
Alexander Privitera is a Senior Fellow and Director of AICGS’ Business & Economics Program.