Five reasons the euro-optimists are wrong

June 21, 2013

Hope springs eternal in the hearts of the European optimists. Despite the fact that Europe is still mired in its longest post-war economic recession and despite every sign that austerity fatigue now characterizes Europe’s beleaguered periphery, the optimists cling to the hope that an economic recovery is just around the corner and that somehow Europe will muddle through its economic and political crisis.


A man reads below a sculpture in Turin. (Alessia Pierdomenico/Bloomberg News)

Sadly this optimism is not well grounded. Rather it rests on a series of myths, which time will tell are no different from the wishful thinking entertained by European policymakers over the past three years.

Myth 1: The European economy is about to recover. Ever since the European debt crisis began in early 2010, optimists have assured us that the economic recovery was just around the corner. Yet that economic recovery has proved to be elusive, especially in the European economic periphery. Delaying that recovery has been the application of severe budget austerity at a time that the troubled European banks have been cutting back on credit. This has all been done within a euro straitjacket that has precluded devaluation as a means to boost exports, which might have served as an offset to highly restrictive domestic demand management policies.

Today the economic policy mix in the European periphery is little different from its immediate past. Although there has been some relaxation in the budget austerity being required of euro members by the European Commission, one still has countries deep in recession being forced to pursue budget austerity within a euro straitjacket. And they are now being required to do so at a time that Europe’s credit crunch persists, the external economic environment has deteriorated, and the euro is now appreciating.

This all begs a question that the European optimists prefer not to ask. If this same sort of economic policy mix deepened Europe’s economic recession in the past, why will it not deepen that recession in the period that lies immediately ahead? And if the European recession does indeed deepen, why will the European banks’ troubles not worsen, and why will Europe’s credit crunch not be more prolonged?

Myth 2: Markets are regaining confidence in Europe. The optimists point to the marked narrowing in European interest rate spreads over the past year as a sure indication that markets are impressed by the improvement in European economic fundamentals. They do so seemingly oblivious to the Wall Street adage that when the winds are strong even turkeys fly. Nor do they seem to pay attention to the fact that those winds have never been stronger considering the unprecedented pace at which the Federal Reserve and the Bank of Japan have been adding to global liquidity. The question that the optimists do not ask is why once the Fed and the BOJ music stops countries with unsustainable public debt dynamics will not be subject to the market’s full fury as has happened all too often in the past?

Myth 3: The European Central Bank provides a safety net for the euro. The optimists take much comfort in Mario Draghi’s pledge to do whatever it takes to save the euro and in the ECB’s Outright Monetary Transaction (OMT) program announced last September that was intended to give substance to that pledge. However, they gloss over the fact that the activation of the OMT program for countries like Italy and Spain is very much conditioned upon those countries first negotiating IMF-style economic adjustment programs with the European Stability Mechanism. They also choose to ignore the clearest of signs that the political circumstances of Italy and Spain are such that those countries are progressively losing their willingness to continue with budget austerity and structural reform.

Myth 4: Europe’s economic recession will not undermine its politics. The optimists do not tire of making the point that high as European unemployment rates might be today, Europe need not fear a return to the politics of the 1930s. This blinds them to the substantial erosion that has already occurred over the past two years in the popular support for the established political parties in countries like Greece, Italy, Portugal, and Spain. It also blinds them to the bailout fatigue that is now all too evident in countries like Germany, Finland and the Netherlands. The question that they choose to duck is why a prolonged period of extraordinarily high unemployment in the period ahead will not exacerbate the political tensions already so apparent between Europe’s South and its North.

Myth 5: Everything will change after the German elections. Ever hopeful, the European optimists believe that once the September 2013 German elections is out of the way Germany will throw its full support behind an early move toward a European banking and fiscal union. Little attention do they seem to pay to the fact that all the major German political parties are very mindful to how German taxpayer money might be spent. Even less attention do they seem to pay to the domestic constitutional obstacles or to the visceral opposition of the respected Bundesbank that lie in the way to any such move.

One has to hope that the five myths sustaining the European optimists prove to be well-founded. However, both European and non-European policymakers would be making a big mistake to base their policymaking on such wishful thinking

Desmond Lachman is a resident fellow at the American Enterprise Institute.

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