It’s Europe’s Economic Growth, Stupid

By Desmond Lachman

European policymakers are clinging to the forlorn hope that the eurozone crisis can readily be defused by putting in place national unity governments in Greece and Italy.

Hope springs eternal among European policymakers. As Greece now verges on a hard default and as Italian bond yields soar to dangerous levels, European policymakers cling to the forlorn hope that the European crisis can readily be defused by putting in place national unity governments in Greece and Italy. By so doing, they choose to turn a blind eye to the highly compromised public finances that brought us to this impasse and that are all too likely to drive the eurozone apart in the year ahead.


The sad truth is that whatever complexion European governments might take, Europe’s periphery will be unable to avoid a deepening of its economic recession. This deepening will occur as the peripheral countries are forced to continue applying IMF style hair-shirt fiscal austerity packages to address their acute public finance problems. This is all the more so the case since they are already experiencing economic weakness and very serious banking system strains.
Stuck within a euro straightjacket that precludes currency depreciation to stimulate export growth, the application of major austerity policies is bound to lead to further economic contraction. And further economic contraction will again result in budget shortfalls and a further exacerbation of these countries’ debt problems. It is also bound to heighten social tensions and to erode those countries’ political willingness to stay the course.
Compounding the periphery’s problems is the fact that the European core economies are already slowing abruptly. In addition, European banks are already cutting back on lending in an effort to shore up their balance sheet positions, which are threatened by large loan losses on their peripheral lending.

Despite economic weakness, the core countries are now engaged in budget tightening, which, albeit on a very much lesser scale than that in the periphery, is all too likely to tip these countries into recession.

Despite economic weakness, the core countries are now engaged in budget tightening, which, albeit on a very much lesser scale than that in the periphery, is all too likely to tip these countries into recession. And a recession in Europe’s core is the last thing that the European periphery needs. It end any hope that countries in the periphery might be able to export their way out of their problems.
While Greece has finally succeeded in putting in place a technocratic premier, its economy remains in freefall. Over the last four quarters, Greece’s economy has contracted by 7.25 percent and its unemployment rate has risen to over 18.5 percent. Rather than recognize that savage fiscal austerity within the straightjacket of euro membership has brought Greece to its present impasse, European policymakers prefer to fantasize that it was former Prime Minister George Papandreou’s dithering that caused the Greek economy to collapse.
European policymakers are now hoping that the newly appointed caretaker Papademos government will somehow turn the Greek economy around. They also seem to be hoping that a voluntary 50 percent debt write down, which in a best-case scenario will reduce Greece’s public debt-to-GDP ratio to a still very high 120 percent, will somehow restore Greece’s fiscal sustainability.
However, the International Monetary Fund and European Union are still demanding of Greece’s new government the very same sort of IMF-style fiscal austerity, to the tune of more than 3 percentage points of GDP in 2012, which contributed so importantly to the Greek economy’s collapse. As its economy continues to contract under the weight of IMF-imposed austerity and as social tensions again come to the boiling point, it is difficult to see how Greece will be able to avoid a hard default over the next few months.

European policymakers prefer to fantasize that it was former Prime Minister Georges Papandreou’s dithering that caused the Greek economy to collapse.

European policymakers are also hoping that the Italian crisis will soon be defused now that Silvio Berlusconi has finally given way to a Mario Monti government. However, it is difficult to see how Monti is going to be able to stave off a serious Italian recession, even if he manages to get a recalcitrant Italian parliament to approve all of the measures being demanded by Italy’s European partners.
As suggested by a more than 10 percentage point decline in its purchasing manager index, Italy is already in a recession that will only be exacerbated by budget tightening and by very unsettled financial market conditions. And if Italy does succumb to a serious recession, there is little prospect that it will be able to prevent a significant increase in its already high public debt-to-GDP ratio. This will be particularly the case if the Italian government is forced to continue borrowing at very high interest rates.
It is perhaps too much to expect European policymakers to take pre-emptive action to forestall a wave of disorderly defaults in the European periphery. However, the least one might hope for is that European policymakers anticipate the high probability of such an outcome and quickly infuse capital into their banks to allow them to withstand the large loan losses that lie ahead. For without such action, there is the all too real risk that the European banking system will have its Lehman moment in 2012 and experience a major credit crunch that will have very untoward consequences for the rest of the global economy.
Desmond Lachman is a resident scholar at the American Enterprise Institute.