European Doldrums

European economies are faltering.  The German economy contracted in the second quarter, as did those of France and Italy. Growth in Spain and the Netherlands was not enough to offset the slowdown in the Eurozone’s largest members.  An escalation in the confrontation with Russia would send shockwaves rippling from the Ukraine westwards that world worsen the situation.

The continuing slump confirms Jay C. Shambaugh’s observation (which appears in his paper in the new volume, What Have We Learned? Macroeconomic Policy After the Crisis) that much of what happened during the global financial crisis was consistent with standard international macroeconomics. For example, countries with flexible exchange rates were able to adjust more easily to the shock than those with fixed rates. Shambaugh also compares unemployment rates in the Eurozone with those across the U.S., and notes that while both the range and standard deviation of unemployment rates began to fall in the U.S. in 2010, the dispersion of national unemployment rates continued in the Eurozone. Labor conditions improved in some countries, but not others. Shambaugh cites this as evidence that there is a lack of adequate shock absorbers, such as labor mobility, within the Eurozone.

These structural problems have been exacerbated by fiscal austerity policies. Governments have sought to reestablish fiscal balance despite the impact on economic performance. The latest announcements of lowered growth have led to calls for relaxing fiscal constraints. But the incoming head of the EU Commission, Jean-Claude Juncker, shows little interest in relaxing the limits on fiscal policies, nor does German Chancellor Angela Merkel.

This leaves (once again) Mario Draghi and the European Central Bank as the focus of hope and attention. The central bank is waiting for the impact of policy measures announced in June to take place. But the disappointing economic news only reinforces calls for the ECB to enact a European version of quantitative easing.

The European GDP data have troubling implications for the larger issue of European debt. Last April, the IMF offered projections for the debt/GDP ratios this year and next:

2014 2015
France 95.8 96.1
Greece 174.7 171.3
Ireland 123.7 122.7
Italy 134.5 133.1
Spain 98.8 102.0
Eurozone 95.6 94.5

The new data will not improve the forecasts for these countries. Greece’s situation, in particular, appears as dire as ever. The Greek government hopes that a cyclically-adjusted fiscal surplus of 2.1% for 2013 will allow it some reduction in the interest rates it must pay and an extension of debt repayments. But the official targets for debt/GDP ratios of 124% in 2020 and 110% in 2022 appear unrealistic.

In a recent paper by Manuel Ramos-Francia, Ana María Aguilar-Argaez, Santiago García-Verdú and Gabriel Cuadra-García (all of the Banco de México) that appeared in the English edition of Monetaria, the authors compare the Latin American debt crisis with the European crisis. They point out that the macro imbalances and the magnitudes of the debt are larger in the peripheral European countries than they were in Latin America. Moreover, the Europeans are not able to rely on exchange rate devaluations to deal with the costs of fiscal austerity. They also remind us that the Latin American situation was finally resolved in 1989 by a reduction in debt and the issuance of “Brady bonds” (see Chapter 4 here), and suggest that some form of debt relief be granted in Europe.

It took seven years from the outbreak of the Latin American crisis for a resolution to be achieved. By that reckoning, European countries have several years of continued stagnation ahead. Political leaders who have seen their predecessors swept out of office by angry voters may not be willing to wait that long.