The Future of the Eurozone

by Tim Wallace, July 2008 

The outlook for many eurozone economies is fairly grim, driven in part by the recent ‘credit crunch', and low consumer, investor and business confidence, as well as the current strength of the euro, which has weakened the competitiveness of export industries.

The current slowdown is likely to hit countries such as Spain and Italy hardest - according to Lehman Brothers, ‘The Spanish economy is the clearest victim of the credit crunch, just as it was the main beneficiary of the credit boom'. Whilst Spain has reduced its level of government debt significantly in recent years, and so has some room for maneuver in terms of fiscal policy, Italy has no such luxury - with public debt still amounting to around 103% of GDP. However, the Italian government is still looking to use fiscal stimuli to boost the economy, through bonds from the European Investment Bank, to circumvent the 3% limit imposed on budget deficits under the Maastricht Treaty. With the Spanish housing market in rapid decline, and unemployment soaring to over 10%, as well as Italy experiencing negative GDP growth in the last quarter of 2007 and 2nd quarter of 2008, there are no expectations of a let-up in the near future.

Ireland, too, is suffering from a housing ‘bust', but, thanks to its relative competitiveness and, in terms of growth, robust starting point should not see the recession which is imminent in these other two economies.

Portugal, on the other hand - which had recently been showing signs of recovering from a relatively long period of slow growth - has found itself stifled, with predictions suggesting that growth will stay below around 1.5% until 2011.

Many countries have seen their industrial sectors hit particularly hard by lower than expected growth in demand internationally, as well as the current strength of the euro. For example, industrial output in Germany and Greece has fallen by 2.4% and 6.6% respectively over the past year. In Greece, this fall occurred despite economic growth as a whole expected to remain above that of many other countries in 2009, at 3.3% (according to the European Commission).

A variety of other countries, such as Luxemburg, Austria and Malta have seen their economic growth dented, but not nearly as severely as Italy and Spain. Similarly, France and Germany are suffering to an extent, but should weather the storm without too much damage, as their economies are less reliant than those of Britain and Spain on readily available credit, and also because the euro is expected to lose some of its strength relative to the US dollar in the coming eighteen months.

The main concern in these countries is that government debt will increase by several percentage points, undoing the efforts of the past few years which have seen the majority of countries at least trying to reduce their levels of state debt, with varying success. Such problems stem from the current atmosphere of high inflation which prevents the ECB from cutting interest rates significantly to provide a monetary stimulus to the eurozone economies, and so their respective governments are resorting to fiscal stimuli.

In terms of a comparison with eurozone countries, British GDP growth is expected to fall fairly firmly, with predictions from Mervyn King of ‘the odd quarter or two' of contraction over the next eighteen months, and consumer confidence falling dramatically (around 80% expect a recession to occur). Much of the country's current woes are blamed on the lack of cheap credit.

Denmark experienced a quarter of contraction at the start of 2008, and GDP growth is expected to remain below 1% for the next two years, due to low investor and consumer confidence, despite unemployment being low, at around 3%.

There are a variety of factors which could exacerbate the current difficulties.

Firstly, US growth: with fears of an anti-inflationary interest rate rise occurring in the near future, and expectations of negative GDP growth in the second half of 2008 (according to the IMF), a further decline in global growth and export demand may push economic growth in the eurozone (and Britain) even lower.

ECB policy: Luxembourg's Finance Minister Jean-Claude Juncker recently declared that ‘the fight against inflation is of the highest importance'. If such policy is followed by the ECB then they may ignore the severe troubles in countries such as Italy and Spain, and look to the reasonable performance of countries such as France and Germany, and decide to raise interest rates to combat inflation. Again, this could tip more economies closer to recession.

Labour cost corrections: according to The Economist, some of the woes of countries such as Spain are caused by a lack of labour competitiveness when compared with a country such as Germany. If this imbalance is only addressed slowly, and reforms are not carried out in the near future, this could lead to a longer recession than was previously imagined. A key cause of such imbalances appears to be the persistence of different interest rates across the eurozone - for example, whilst average inflation is at 3.6% in the Eurozone, Ireland's is currently 4.2% and France's is only 3%.

Slovakia: Slovakia is due to join the euro in the very near future. However, further imbalances may be caused by this move, with fears of excessive government spending, as well as inflationary pressures caused by the lack of monetary independence in the period before joining the EMU.

Nonetheless, there are also possibilities that economic conditions could improve - not least the recent falls in oil prices, and the fact that the US economy may not be in as bad shape as previously feared - with, for example, the financial sector possibly proving more stable than initially expected.

All in all, the outlook is still unpleasant. Many countries have undergone fewer economic reforms than was hoped for at the launch of the EMU, and divergences in competitiveness have come home to roost following the recent turmoil in the financial markets. For many - though not all - eurozone economies there will be a period of stagnation or recession lasting for at least the next eighteen months, and quite probably longer for some (most notably Italy, Spain and Portugal), even if the economic picture is brighter than some fear.