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Analysis
Crucial year for euro bedevilled by politics and economics

Crucial year for euro bedevilled by politics and economics

Testing timetable to resolve Berlin coalition wrangling 

by David Marsh in Frankfurt

Mon 18 Nov 2013

After all the efforts to build up euro area confidence during the last three years, as well as painful and effective policy corrections in the deficit countries, politicians, investors and voters might have expected calmer waters next year. In fact, the worst is not over.

The next 12 months will be the euro bloc’s year of maturity. Unfortunately, for reasons that are beyond anyone’s influence, a lot of things are happening at the wrong time.

The first big problem is politics. The European parliament elections next May look likely to be a disaster for mainstream parties. Europe’s stalwarts have been claiming for years that the European-based assembly is the true repository of European decision-making. Those who have given the parliament so many extra powers may now regret their enthusiasm.

Popular discontent about sluggish growth and high unemployment, as well as apathy-driven low turnout, is likely to strengthen substantially the scores of anti-European parties, which may make up 25% or more of the future parliament.

At a time when the European assembly has important influence on key pieces of European law on trade and commerce, and on the future banking union, the swing to the Eurosceptics will dent efforts to reform Europe. Low-level belligerence between creditor and debtor countries will be augmented by skirmishing across the political spectrum.

Policy paralysis in Germany, where attempts at coalition-building between the Christian Democrats (CDU) and Social Democrats (SPD) have hit numerous hurdles, reinforce the impression of political drift. Whatever the buoyancy caused by multi-layered cheap central bank money, all this cannot fail to unsettle financial markets.

The timetable for Germany’s two big parties to hammer out an accord is a tight one. Negotiations on forming a Grand Coalition have been bedevilled by differences on individual items, ranging from tax and spending through to legalisation of gay marriages. The CDU and SPD need to agree on strategy and on key ministerial appointments by 28 November. This would allow a fortnight for the SPD to put the agreement to a referendum by party members, with the result to be announced on 15 December.

Two days later, on 17 December, Angela Merkel is due to be re-elected as chancellor by the Bundestag. On 19 December she travels to Brussels for a crucial European summit that should put the finishing touches for the banking union plans, ahead of next year’s dissolution of the European Commission and election of a new parliament. There’s plenty of room for the SPD – wounded by its poor German parliamentary election score on 22 September and sensing that it cannot really lose in the coalition talks with Merkel – to attempt to blackmail her on key issues dear to Social Democratic hearts. There is still an outside chance that the SPD could stage an anti-Merkel coup and achieve a majority in the Bundestag by teaming with the Greens and the far-left Linke party. Or, after a real deadlock, we may see new elections in Germany next year. If Merkel goes to Brussels weakened by bruising Berlin encounters, or, worse, without a coalition agreement, then Europe’s plans for 2014 as a year or renewal will be scuppered before New Year.

All these issues are made still more difficult by renewed weakness in European growth in the third quarter. Worse-than-expected figures for Germany, France and Italy dragged down euro area expansion to just 0.1% from 0.3% in the April-June quarter. This validates the European Central Bank’s (ECB) interest rate cut the previous week, aimed at forestalling the risk of deflation that some ECB council members plainly take more seriously than others.

The ECB’s review of European banks’ books over the next 12 months takes on new significance. The ECB’s investigations and rigorous stress tests are a necessary means of rebuilding confidence in European banking. The plan was to carry them through at a time of accelerating recovery. Instead, we’re still in an unstable period of the economic cycle, with acute risks of setback. On the regulatory side, the ECB is understandably bringing the banks to heel, with restrictive impact on credit, as numerous indicators demonstrate. A report by rating agency Fitch shows that, in anticipation of stricter capital rules, the largest European banks increased their exposure to sovereign debt 26% in 2011 and 2012, while cutting corporate lending by 9%.

On the monetary side, to counter much-trumpeted deflationary impulses especially in the peripheral countries, the ECB is moving in the opposite direction, lowering interest rates in a way that representatives of the creditor countries on the ECB council find difficult to accept. These complications could bring a negative feedback loop into the stress test results. There’s a clear threat of a vicious circle. The net effect of these developments will damp forces for recovery in Europe.

And we have to consider the mood outside Europe too. Divisions between Europe and America have occupied the headlines. There’s no indication things will get better. The furore over US intelligence activities, America’s lack of interest in the overseas impact of its budget dispute, the massive rival attractions of China and Asia, looming American energy independence, criticism of German current account surpluses: all this points to transatlantic discord. Europe needs friends and understanding on the international scene. Instead we see growing alienation, mutual irritation and a dull sense that, if and when Europe’s crisis bubbles again to the surface, the Europeans will be sitting alone with their troubles.

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