DO NOT KID YOURSELF THAT THE EUROZONE IS RECOVERING / THE FINANCIAL TIMES COMMENT & ANALYSIS

September 29, 2013 6:06 pm

 

Do not kid yourself that the eurozone is recovering

 

By Wolfgang Münchau

 

The main constraint on the resumption of growth is the failure to clean up the banking sector

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©Reuters

 

Europe’s political leaders have seized on the first uptick in European economic indicators as evidence that their policies are working. Who would have thought that?

 

Eurozone gross domestic product expanded 0.3 per cent in the second quarter of this year. It will probably have expanded again in the third quarter. So if you define the end of a recession as two consecutive quarters of positive growth, you might be tempted to forecast that the recession will end at precisely midnight on Monday with the end of the quarter. If you do this, you are either a fool or someone with an agenda to peddle – or both.

A recession is a broad-based downturn in economic activity. The focus on two consecutive quarters of GDP is at best a shorthand back-of-the-envelope indicator for a normal business cycle. But this is not a normal business cycle. Just look at the order of magnitudes involved. Comparing the first half of 2007 and the first half of 2013, real GDP contracted by an accumulated 1.3 per cent in the eurozone, 5.3 per cent in Spain and 8.4 per cent in Italy.

In the same period investment was down by an accumulated 19 per cent in the eurozone – and 38 per cent in Spain and 27 per cent in Italy. Between the first quarter of 2007 and the first quarter of 2013, employment fell 17 per cent in Spain and 2 per cent in Italy. I would not call the end of the recession until we see a sustained improvement in growth and employment. Once the recession ends, I would expect that we will get back to the pre-recession trendline.

The biggest drag on eurozone growth right now is Italy. The coalition of Enrico Letta, the Italian prime minister, has effectively collapsed over the weekend as Silvio Berlusconi has withdrawn his ministers. The latest political turmoil will prolong the recession as the uncertainty holds back investment.

 

Even a new government will not bring a solution. Italy is stuck with a combination of an unsustainable high level of public debt and no productivity growth. It has essentially two options to adjust – become like Germany, or leave the eurozone. The country is unable to do the first, and unwilling to do the latter. As the economists Francesco Giavazzi and Alberto Alesina calculated in an article in Corriere della Sera last week, it would cost some €50bn to reduce the tax wedge – the difference between labour costs and net income – to German levels. There is simply no political majority in sight for such radicalism. The centre-right prioritises tax cuts on consumption and housing, while Mr Letta’s Partito Democratico vetoes spending cuts. Italy faces no immediate threat for as long interest rates remain low. The country will be able to muddle through for a while until some political or economic shock will force a decision one way or the other.

 

Meanwhile, the single largest constraint on the resumption of eurozone growth is not fiscal policy – which is broadly neutral at present across the single currency area – but the continued failure to clean up the Banks. The growth rate of loans to the non-financial sector turned negative in 2009, showed some intermittent improvements, only to then deteriorate again last year.

Things have not improved since: in August this year loans to the private sector were down 2 per cent over the past year. M3, a broad measure of money in circulation, grew by an annual rate of just 2.3 per cent in the June to August period.

The monetary and banking data are telling us that the economy will teeter on the brink of zero or low growth for the foreseeable future because the financial sector is not supplying the economy with sufficient funds to expand.

Banking union could help, but only if it were to break the relationship between banks and sovereigns and clean up the balance sheets. Yet neither is going to happen. I believe Mario Draghi, president of the European Central Bank, is serious in his determination to produce a clean and honest asset quality review, which will start next month. He certainly does not want to repeat the mistakes of the European Banking Authority, which has lost its credibility with farcical stress tests.

 

But what can he do if governments fail to agree a fiscal backstop for this exercise? Would it not be irresponsible to admit that banks need several hundred billion euros in new capital when that money is simply not there? But without a clean-up of the banking sector, I see no trend change in the monetary and bank lending indicators – and this will postpone the recovery further.

The most positive news we have had in the eurozone has been the growth of Spanish exports, which have risen 11 per cent in real terms from the first half of 2008 to the first half of this year. The improvement of Spanish export competitiveness is substantive, but mostly as a result of cuts in employment rather than wages. It is not clear to me whether an export-led growth strategy of the kind pursued by Germany would be feasible and sustainable for Spain.

Italy’s political and economic implosion, the credit crunch and past austerity are among the main factors weighing on the eurozone today. The recession that started in 2008 continues, once you ditch the silly obsession with two consecutive quarters. It is not about to end.

 

Copyright The Financial Times Limited 2013