The Policy Trap: Is the Euro Crisis Back?

Alexander Privitera

Commerzbank AG

Alexander Privitera a Geoeconomics Non-Resident Senior Fellow at AICGS. He is the head of European affairs at Commerzbank AG. He focuses primarily on Germany’s European policies and their impact on relations between the United States and Europe. Previously, Mr. Privitera was the Washington-based correspondent for the leading German news channel, N24. As a journalist, over the past two decades he has been posted to Berlin, Bonn, Brussels, and Rome. Mr. Privitera was born in Rome, Italy, and holds a degree in Political Science (International Relations and Economics) from La Sapienza University in Rome.

Now in the second half of 2014, the European economy has hit a rough patch, triggering renewed anxiety among policymakers on both sides of the Atlantic. Economists and politicians are still trying to assess whether the U.S. economy is strong enough to pull the weaker euro zone out of its gravitational drift toward chronic stagnation (or even a new recession), or whether, in fact, the danger is that the opposite will happen.

Once again Germany and its apparent reluctance to use its fiscal space to stimulate the economy has come under intense criticism in Washington and elsewhere. Many analysts believe that the underlying friction between Washington and Berlin continues to be caused by a deep disagreement on economic policies—in essence, Washington advocates Keynesian fiscal stimulation while Berlin pushes for austerity and a rigid, rule-based, ordo-liberal economic recipe—and is a further installment of the growth versus austerity debate. It flares up every time doubts about the right path out of the crisis are fuelled by a string of weakening data, increased wobbliness among investors, and vocal interventions by leading European politicians representing very different views. The recent announcement by the French government that, in order to enhance growth, it will once again miss its budget deficit targets—targets contained in the very same rules of the growth and stability pact that Paris helped write—is a case in point. Once again, Germany finds itself accused of being too rigid and therefore the main reason for the prolonged unnecessary economic hardship. Not only is it perceived as reluctant to allow for a more pragmatic approach toward increased public spending at home and in its European neighborhood, but it is also seen as acting as a constraint on more aggressive monetary policies, such as launching outright purchases of sovereign bonds.

The Policy Trap, Or the Inability to Think Big

Critics of the current crisis management see the monetary union still caught in a policy trap that forces member countries to endure unnecessary economic and social hardship. The situation is often described as a vicious circle that condemns economies to stagnation and high unemployment, and risks fueling nationalist forces that represent a challenge to the very existence of European institutions and, last but not least, to its common currency.

Dismissing this somewhat simplified one-sided interpretation out of hand would be a mistake. However, there are other factors at play that are mainly driven by political-institutional considerations. In Europe, the economics of the crisis are tightly knit to the politics of the crisis.

Institutions and governments are currently not only trying to revitalize growth, they are also addressing some structural, economic, and institutional flaws within member countries as well as at the EU level. EU member countries have decided to create a single supervisor for some 130 EU banks. They have strengthened European oversight of member countries’ fiscal budgets. They are trying to regain some of the competitiveness that was lost in the past decade. One of the main goals is to avoid another public debt crisis and foster confidence among international investors. Finally, political leaders are trying to ensure that their governments are not swept aside by nationalistic, centrifugal forces. This exercise requires carefully calibrated decisions. Political considerations often trump purely economic arguments. Economic policy choices have to be wrapped up in packages that can be sold to multiple domestic audiences in different member countries, as well as among investors that are looking for clarity and a clear sense of direction. Simple promises, such as “to do whatever it takes” to save the euro zone from a sudden break up, are rare. Instead, analysts are confronted with the constant need to read between the lines and to reconcile often seemingly contradictory policy statements.

The Exorbitant Privilege of France and Germany within the Monetary Union

So far, it has been impossible for euro zone policymakers to adopt a big bang approach, one capable of addressing many institutional, political, and economic weaknesses at once. If it is true that European integration only makes determined leaps when leaders have their backs against the wall, we have not seen anything yet. While the monetary union has indeed come under attack and there have been undoubtedly many instances when individual governments were pushed and punished by investors, by their European peers, as well as by their voters, the two core nations that represent the political and institutional underpinnings of the monetary union—France and Germany—have never been seriously threatened, neither by a serious economic downturn nor by a sharp increase in the cost of financing their budgets. As a result, it is arguable that neither France’s nor Germany’s leadership truly faced stark choices that were driven by overwhelming domestic pressure.

Recurrent domestic bouts of public outrage about various euro zone bailouts don’t qualify, as long as the German economy fared well, thanks in part to its status as safe haven within the euro zone. Even the recent appearance of German euro skeptics on the political scene needs to be taken for what it is: a disturbance rather than a threat.

Even France, despite its much weaker economic performance, never suffered from skyrocketing yields on its sovereign bonds. Interest rates were pegged to those of Germany, and this cushioned the adverse impact on the real economy of very timid public spending cuts. Various measures taken by European leaders allowed German and French banks exposed to weaker euro zone member countries to retreat and minimize losses. The sharp contraction in economic activity in neighboring countries since 2010 never caused a deep recession in France or Germany. France’s situation was and still is far more comfortable than what program countries such as Spain or Ireland ever had to face. Even Italy, now teetering at the edge of the third recession since the outbreak of the financial crisis in 2007/2008, fared much worse that France.

However, the prolonged slump in France and the softness of recent German data have suddenly spurred a new sense of urgency among European policymakers. The deal between Paris and Berlin on which the rescue of the euro zone has rested so far, based on the understanding that both countries will do what is necessary to shield each other from real pain, is increasingly strained. This explains why the cautious step-by-step approach—muddling through—that has been a key feature of the efforts to overcome the crisis could face serious challenges. Leaders in France and Germany know what they want to avoid—a breakup of the euro zone—but they are unsure about their countries’ direction within the monetary union. This lack of ambition could prove to be insufficient to put the monetary union back on track.

Against this background, the recent economic wobbliness can be seen as a test for the Franco-German approach to the crisis. Economic reality is once again threatening to undermine the foundations of the political deal between France and Germany. Furthermore, it risks putting additional strain on the central bank, the only European institution that has managed to gain rather than lose credibility during the crisis.

The Role of the ECB: Caught between a Rock and a Hard Place

Following the comprehensive assessment of their balance sheets, as of 4 November 2014, euro area banks will be supervised by the European Central Bank (ECB).  This new phase in the history of the common currency matters for all the reasons cited above: by loosening the link between banks and their sovereigns, the banking union should contribute to addressing the problem of financial fragmentation and fostering further European integration, at the very least in the banking sector. At the same time, European banks should become less prone to posing a systemic risk to financial stability. Last, renewed confidence in the banking system should allow the ECB to unclog transmission channels that have turned into a bottleneck for traditional forms of credit intermediation since the outbreak of the crisis.

Unfortunately, early hopes that the asset quality review and the stress tests that the central bank has undertaken together with the European Banking Authority (EBA) would be sufficient to foster a return of confidence to the euro zone and spur lending activities to the real economy have not yet materialized. With economic growth continuing to be very weak, fragile, and uneven, many analysts doubt that a more stable banking system will translate into more lending activities to the real economy.

Indeed, the contraction in credit flows has not been stopped. The ECB is merely taking comfort in the fact that the sharp reduction in lending activities has slowed. The central bank now expects lending to pick up in early 2015. But given the deteriorating economic environment, the ECB knows that this could be too little, possibly too late. The ECB has decided that it cannot wait for events to unfold. Some inconvenient, hard truths are finally being spoken. This time the intended audience is primarily France and Germany. Indirectly addressing France (and to some degree Italy), executive board member of the ECB Benoît Cœuré recently had the following message: “Countries that have enacted a more frontloaded reform strategy have, on the whole, seen better outcomes than those that have applied a more staggered approach. Today’s low inflation expectations in the region as a whole may indeed be telling us that the approach was on average too staggered, and that it is time to accelerate. […] Reforms produce both expansionary and contractionary forces in the short term. Designing reforms in the right way and creating a productivity-enhancing environment can maximize the former, and let me add: the faster, the better.”[1]

It would be worth examining whether a front-loaded institutional reform strategy would also have been vastly more beneficial than the staggered, step-by-step approach taken so far. But this is not the role of the ECB. The central bank should only stick to its core mandate: ensuring price stability. However, the reluctance of political leaders to formulate a comprehensive plan for the euro zone has forced the ECB to be more vocal about what needs to be done, in the core as well as the periphery of the monetary union. Even Germany has recently been singled out by various ECB officials, including its president Mario Draghi as well as Cœuré, as in need of doing its own homework: “While the full benefits of these efforts (i.e., reforms) are still emerging, aggregate demand should counteract the potentially destabilizing effect of lower prices and higher real interest rates. This can be done by fiscal policy, when it is available without questioning long-term debt sustainability. And it can be done by monetary policy, even when interest rates have reached the lower bound, by expanding the central bank’s balance sheet and channeling liquidity to the real economy. This is what the ECB has been doing and will continue to do. It is sometimes argued that monetary policy can weaken the incentives to reform. I do not share this view. Price stability, defined as the inflation rate being below but close to 2%, is the anchor of the adjustment process and it is our duty to deliver it within our mandate. Very low government bond yields can indeed weaken the incentives for sound fiscal policies, and this is why we need strong and credible fiscal rules. But the suffering of young and long-term unemployed in our countries should suffice as an incentive to reform.”[2]

Overcoming the Franco-German Impasse

The ECB is pointing to the core of the problem: France should finally speed up its urgent reform process and Germany should not stand in the way of unconventional supportive monetary policies implemented by the ECB. The governing council is obviously worried about the Franco-German impasse. The real strength and weakness of the monetary union is the relationship at its core, between France and Germany, which is becoming increasingly dysfunctional. If the two countries agree on a common agenda that addresses other member countries’ needs, the Franco-German engine propels the rest of the union. But if the two partners disagree or, even worse, decide to go it alone and apply different set of rules to themselves than they do to other EU or euro zone members, they should be not surprised if the whole euro zone building starts to shake. Leadership means acting in its own interests as well as promoting those of others. That is exactly what is needed now, six long years after the outbreak of the biggest financial crisis since 1929.

Alexander Privitera is the Director of AICGS’ Business & Economics Program.


[1] Keynote speech by Benoît Cœuré, Member of the Executive Board of the ECB, Economic conference, Latvijas Banka, Riga, 17 October 2014,

[2] Ibid.

The views expressed are those of the author(s) alone. They do not necessarily reflect the views of the American Institute for Contemporary German Studies.