Europe’s race between economics and politics
Greece’s problems should be a wake-up call
by Desmond Lachman
Tue 14 Apr 2015
Europe’s political economy is at a critical juncture. At last, there are signs that the continent might be on its way to a meaningful recovery. Yet Europe’s politics appear to be fragmenting at an accelerating rate, a result of thwarted economic expectations. Whether Europe can avoid a downward political and economic spiral will depend on whether the recovery has sufficient force to reverse the last few years’ political deterioration. Greece plays a role here, but the problems go deeper.
Europe’s performance since 2008 has been disappointing. The European Central Bank has been timid about quantitative easing, when most single currency members were forced to pursue austerity within a euro straitjacket. In contrast to the US, where an activist Federal Reserve greatly contributed to an expansion in the US economy to 8% above its pre-Lehman crisis peak, the European economy is still 2% below its peak. US unemployment has declined to around 5.25%, while in Europe it remains stuck at over 11%.
Luckily for Europe, it benefits from strong tailwinds. Over the past six months, international oil prices have roughly halved: manna from heaven for the European consumer. The ECB has finally embraced full-bodied QE by buying €60bn a month in European bonds. This has reduced European long-term interest rates to record lows. Still more important, it has contributed to a 20% euro decline against the dollar, boosting European exports.
Europe’s growth may pick up to 1.5% in 2015, as the ECB is projecting. However, even if that happened, by end-2015 the European economy would still be below its pre-Lehman peak. And overall European unemployment would remain around 11%, more like 25% in Greece and Spain.
Greece’s troubles should be a wake-up call to European policy-makers about the political fall-out from years of economic underperformance. In the wake of a six-year recession, which saw Greece’s GDP decline by almost 25%, the Greek electorate has turned to a radical-left Syriza government, openly hostile to budget austerity and structural economic reform. This has put Greece on a collision course with its European paymasters that could see Greece forced out of the euro before the year is out.
Greece now owes the ECB €104bn. That should give ECB President Mario Draghi sleepless nights, since these loans dwarf the ECB’s €10bn paid-up capital. Two slippery slopes have led the ECB to such exposure. The first was through its secondary market purchases of Greek government bonds at the height of the European debt crisis. The second route was through the ECB’s lending to the Greek banking system, compensating for the bleeding of Greek bank deposits in reaction to depositors’ fears that Greece might be forced to exit the euro. The ECB has done this despite the poor quality of the Greek banks’ collateral.
If Greece defaulted on its official obligations, the ECB would face sizeable losses. Much as the ECB would like to enjoy the preferred creditor status customarily afforded to the IMF, the ECB’s relative exposure to Greece (at around 30% of Greece’s overall government debt) is too large to afford it that luxury.
Since embracing QE, the ECB has faced strong opposition to its unorthodox approach, particularly in Germany. At this delicate juncture, the last thing that the ECB now needs is a further erosion in support as a result of Greek loan losses.
Sadly, the political deterioration spawned by years of European economic underperformance is not confined to Greece. Indeed, across Europe the political centre appears to be crumbling. If containing the fall-out from a possible Greek euro exit underlines the need for reinvigorating the European economy, so too does Europe’s crowded electoral calendar. Over the next 12 months, highly contested elections are to be held in the UK, Portugal, Spain, and Ireland.
Europe’s longer-run economic and social prosperity would seem to hinge crucially on whether its economic rebound outpaces its deteriorating politics. European policy-makers need to move quickly in supporting the ECB’s easing with meaningful structural economic reform and a relaxation of budgetary austerity.
Desmond Lachman is a resident fellow at the American Enterprise Institute in Washington. He was formerly a Deputy Director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.
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