The Future of the Euro
What's wrong with European economic performance?
Erik Jones / Sep 2015
Michel Sapin and Wolfgang Schäuble, the finance ministers of France and Germany. Photo: European Union
Pessimism is building across the euro area about economic performance. Growth has slowed in most euro area economies, even as inflation remains persistently low and unemployment persistently high. The question is whether to blame this poor performance on external factors or on decisions made by European policymakers. If this is just another patch of bad luck, then the only challenge is to batten down the hatches and ride it out. It would be more worrying, however, if Europe’s economic policymakers have set their economy sailing off in the wrong direction.
The easy answer is to blame the outside world. Growth in emerging markets is slowing. This is not only sapping demand for European exports but also pushing down commodity prices and increasing volatility in exchange rates. At the same time, other major economies are underperforming. The recovery in the United States is quicker than in Europe but it is still too uneven for the U.S. economy to help pick up slack elsewhere. Japan is much weaker. Worst of all, Europe is surrounded by tragedy. The human cost of violent conflict and desperate migration is all too apparent; what is less obvious is the toll on European businesses that have lost access to neighbouring resources, relationships and markets.
Blaming the outside world, however, takes interdependence for granted: Europe exists in a globalized economy and so has to accept the consequences of that fact. But that does not mean policymakers should be regarded as bystanders. National economies may be vulnerable to world market influences but economic policymakers can influence the sensitivity of national economic performance to changes in conditions elsewhere. The architects of European integration were quick to recognize this possibility – and equally quick to take advantage of it. To a great extent, the drive to complete Europe’s internal market, minimize intra-European exchange rate volatility, and strengthen economic policy coordination in the late 1980s and early 1990s was a response to the global economic tumult of the 1970s and early 1980s. We could say much the same about the origins of the European project in the 1950s and about the expansion of European economic competencies that took place between the negotiation of the Amsterdam Treaty and the announcement of the Lisbon strategy at the turn of the century.
The response of European economic policymakers to the Great Recession is different. Mitigating European sensitivity to global market forces is less of a priority; leveraging global demand to stimulate domestic economic performance is more important. This shift is most apparent in the change in current account positions. Before the recent economic crisis, some European countries ran surpluses and others ran deficits, but the euro area as a whole was close to balance with the outside world. With hindsight European economic policymakers argue that persistently large current account deficits within Europe need to be corrected. There is logic to that assertion. Nevertheless it has translated into a general tendency for all euro area countries to strive for a current account surplus. The rhetoric of ‘competitiveness’ elevates that tendency to the level of virtue. Yet if Europe’s economic policymakers strive to run a competitiveness-oriented export-led growth model, they can hardly be surprised if their success will vary with the strength of global demand. Heightened sensitivity to world market forces is baked into the growth strategy they have chosen.
Heightened sensitivity also shows up in the flow of capital. Here we should look at the combination of ultra-low interest rates and unconventional monetary policies. Ostensibly the goal of these policies is to create incentives for investment within Europe. All along, however, the European Central Bank has admitted that there is only limited demand for new borrowing. Hence the most likely impact of ultra-low interest rates and unconventional monetary policy has been to push down on the value of the euro as savers look for higher rates of return in other countries. This is the flip side of the euro area’s current account surplus with the outside world – capital exports and a depreciating exchange rate. Once again, however, the result is to make European economic performance more sensitive to conditions elsewhere. This time the focus is on whether rates of return on European investments in foreign markets turn out to be more volatile than expected and how economic policymakers in other countries will respond to any change in the relative value of the euro. You only have to look at recent events in China to see where this part of the argument is headed.
The choice to leverage global demand has not only increased European sensitivities to world market forces but also may have contributed to global economic volatility. When newspapers report that more than $1 trillion in portfolio capital has drained out of emerging market economies, it is worth wondering how much of that money is European and where it is likely to be headed. So long as euro area economic policymakers strive to run national and collective current account surpluses, you can bet that money is not coming home. More likely, it is headed to U.S. asset markets instead. The result both exacerbates the slowdown in emerging market performance and heightens European sensitivity to U.S. asset market conditions.
With such sensitivity to world market forces, it is small wonder that pessimism is building about euro area economic performance. External factors are a large part of the explanation. But the fact that these factors are external to Europe does not absolve European economic policymakers of their responsibility. They could have chosen to continue building a European marketplace that engages with the outside world but also insulates national economies from world market pressures. Instead they opted for a strategy that makes Europe’s economies more susceptible to influences from abroad. In this sense, Europe’s bad luck is at least partly of its own making. Battening down the hatches is unlikely to solve the problem; Europeans need to start considering whether it is time to change course instead.