Still life in the Eurozone economy

A deliberately ambiguous title. Because there really is still life in the eurozone economy and reports of the demise of the upswing are premature. But, watching the euro area grow is also like looking at a still life painting – there is not much action. Nor is there much action on the needed reforms to tackle the existential threat to the euro from weak growth and lack of banking system and fiscal integration.

The ‘trend growth’ rate for the euro zone is only about 1% and growth has slowed to about that rate at present. Barring accidents, growth should keep going and, if world conditions improve, some faster growth is likely in 2020-21. But if Europe faces a new recession any time soon, the euro will be under existential pressure once more.

Europe’s growth is being held back by the world-wide manufacturing slowdown, mainly due to weakness in China and uncertainty over trade policy. The European economy and especially its leading economy, Germany, has long depended on exports to drive growth. But the good news is that despite this source of weakness, investment is holding up tolerably well and consumers are doing fine. Investment is holding up largely because there is still a backlog after the double-dip recession in 2008/2012. Consumers are holding up because employment is growing at a solid rate, unemployment is back down to rates only a little above the peak of the last economic upswing and wages moved up smartly last year.

Meanwhile the ECB has moved to a more dovish stance, in line with the Fed’s move earlier in the year. Admittedly there is not much the ECB can do with rates already negative. But money supply M3 is still growing solidly and has actually picked up slightly recently. Core inflation is still stuck at around 1% (versus the target of ‘just under 2%) and the ECB is happy to maintain a very easy monetary policy.

So is the euro area economy healthy? Yes and no. Near full employment, with growth at around (or even just above) trend, and inflation well under control is truly a fine place to be. But the potential for the politics of the euro area and more broadly the European Union to cause an upset, still remain. In the short term the risk of a no-deal Brexit is rising as the two contenders for the UK’s Conservative Party leadership box themselves into a tight negotiating position with very little time left before the 31 October deadline. But a no-deal Brexit is severely damaging only to Ireland (and the UK). For the euro area as a whole the effect would be noticeable but small – perhaps of the order of 0.2-0.4% of GDP over a year.

The two biggest problems for the eurozone remain the Italian government’s hostile stance and the continuing weakness in European banking systems, particularly Italy’s but also Germany’s. This weakness is partly the legacy of the double-dip recession with bad loans still high. More fundamentally it the so-called ‘doom loop’ problem, where European banks own too much debt of their own government. If governments default they take their own banks down with them.

The risk of a confrontation between the Italian government and the Commission is small this year, largely because the new Commission has yet to be formed. But a confrontation is probable in 2020 unless the Italian government takes a more conciliatory approach to its fiscal position.

But the confrontation with the EU isn’t really the Italian crisis. The Italian crisis is that the present government is failing to do any of the necessary reforms that might put Italy on a firmer economic growth track and thereby cement its position in the euro area. Instead it is posturing in a way that is stoking anti-euro feeling while keeping the economy weak.

Come the next European recession, a new euro crisis looks almost inevitable without a change in approach in Rome and, as well, significant progress on integrating European banking. The former depends on Italian voters. The latter, mostly on German voters who reject anything that might make them foot the bill. So, the bottom line is dont worry too much about the European economy in the short term, but do worry about the long term.