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After the crisis

16 Dec 2013 By Hugo Dixon

The hot phase of euro crisis may be over. But the zone will limp on for years with low growth and high unemployment unless further action is taken on three fronts: bank balance sheets must be cleaned up, monetary policy loosened and more free-market reforms adopted.

The latest news from the euro zone’s various battlefronts is fairly encouraging. GDP in all the problem countries, with the exception of tiny Cyprus, is expected to grow next year. Budget deficits, one symptom of the crisis, are being cut. Current account deficits, the other main symptom, are coming into balance.

Ireland, the poster child of the harsh recipe of fiscal austerity plus structural reform, has just exited its bailout programme. Portugal may do so next year. Even Greece is toying with the idea of issuing government bonds towards the end of 2014.

Among the bigger economies, Spain is on the mend. The outlook is murkier in Italy. But even there, the election of the youthful Matteo Renzi as leader of the centre-left Democrats gives some ground for hope that he will work with Enrico Letta, the prime minister, to reform the country.

Letta is moving smartly to reform the political system and constitution – last week finally abolishing government funding for political parties. What’s less clear is whether he will be able to reform the economy or cut public debt, which will end this year at an eye-popping 133 percent of GDP.

It’s fashionable to think of France as the sick man of Europe. President Francois Hollande has certainly done too little to cut back France’s welfare state or to boost the economy’s competitiveness. But the cyclical upturn has probably come just in time to prevent France being sucked into a crisis.

Still, the euro zone is not in good shape. The unemployment rate is over 12 percent – and in Spain and Greece it is more than double that. The European Commission expects euro zone GDP to grow by only 1.1 percent in 2014.

The long grind carries with it the risk of political explosions. The main flashpoint next year could be May’s European Parliament elections, in which traditional centre-left and centre-right parties are expected to perform poorly as voters switch to protest groups.

In France, the beneficiary is likely to be the far-right National Front; in Italy, the Five Star Movement, run by the comedian-turned-activist Beppe Grillo; in Greece, the radical left Syriza; and, beyond the euro zone in the UK, the eurosceptic UKIP.

Electoral breakthroughs by previously fringe groups in the European elections don’t have to cause earthquakes back at home. Governments could theoretically dismiss them as irrelevant to national politics. But backbenchers are likely to get jumpy, making it harder for governments to govern.

Meanwhile, schemes for a deeper fiscal and political union in the euro zone have been put on ice. This is good news, despite the conventional wisdom that the zone needs a fiscal union to complement is monetary union. But further centralisation would probably make it more sclerotic. What’s more, the peoples of Europe are not remotely ready to create a super-state.

This does not mean that the euro zone can afford to sit on its hands. In order to mitigate the political risks, it needs to pep up its growth rate.

The two biggest things that can be done in the short to medium term are both in the hands of the European Central Bank. First, the ECB needs to supervise a clean-up of bank balance sheets, so that zombie lenders no longer drag down many countries’ economies.

The central bank is due to take over responsibility for supervising banks next autumn. In advance of that, it is subjecting them to an asset quality review. If this is sufficiently stringent, the banking system will be much healthier.

Some pundits are worried that Europe’s so-called banking union has not been properly completed. Later this week, Europe’s leaders may agree a complicated compromise on one element of this project, the “resolution mechanism” for handling bust banks. But in the short run, this is a sideshow compared to managing the asset quality review properly.

The other big item on the ECB’s agenda is getting inflation up to its target of below but close to 2 percent. It is forecasting inflation of 1.1 percent next year and 1.3 percent in 2015. Such low inflation rates make it harder for the euro zone to grow rapidly, not least because debt burdens weigh more heavily.

Mario Draghi, the ECB’s president, said this month: “We are fully aware of the downside risks that a protracted period of low inflation does imply”. What’s not clear is whether the ECB is prepared to be decisive enough. Now that interest rates are rock bottom, it should follow the United States and UK and engage in quantitative easing – essentially buying government bonds in the market.

Governments shouldn’t leave all the heavy lifting to the ECB. They need to keep liberalising their labour and product markets at home. They also need a renewed drive to free up markets at the level of the EU, especially completing the single market in services. The time to do so will be after the European elections, when a new European Commission will be chosen. As the EU moves from fire-fighting to building a strong economy, this should be its priority.


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