In between fighting the Crimean War and exiling Alexander Pushkin, Tsar Nicholas I of Russia coined the phrase “the sick man of Europe”. He was describing the feeble state of the Ottoman Empire, whose territories he was picking off in the Caucasus with contemptuous ease. Since then the term has variously been applied to the Austro-Hungarian empire in the run up to the First World War, sclerotic unionised Britain in the 1970s and post-unification Germany in the 1990s.
Now, you can throw a dart at the map of the continent and take your pick of which country most deserves this unflattering label. France, Germany and Italy account for 70% of eurozone GDP. In France growth is flat lining, in Germany it fell by 0.2% in the second quarter and Italy is in recession for the third time since the 2008 global financial crisis.
On holiday beside Lake Como it was easy to forget that the Italian economy is 9% smaller now than it was six years ago. It was bigger in 2001. But even in the prosperous north, the walls in the hinterland of tourist areas are adorned with graffiti, perhaps a by-product of 45% youth unemployment, and if the occasional Ferrari or Lamborghini passes you on the poorly maintained roads, it invariably has foreign number plates.
In 1987 Italy’s per capita income briefly exceeded that of the UK. Now it is below Mexico’s. Italia malata (ailing Italy) is hardly a new story. But the malaise is spreading. Feeble growth, double digit rates of unemployment and high levels of national indebtedness are the new normal in the eurozone. The new, new, normal is deflation. Eurozone inflation has fallen to 0.3% and Greece, Portugal, Spain and Slovenia are suffering outright deflation.
Debt plus deflation is not a good equation. Deflation increases the real cost of debt. Italy has a debt-to-GDP ratio of 135%, Portugal 133%. Already high, and by many traditional measures unsustainable, these ratios will increase further if deflation takes hold. Ever increasing interest payments will sap more life from already enervated economies.
Super Mario to the rescue?
In February European Central Bank president Mario Draghi said: “Inflationary expectations continue to remain firmly anchored and we do not see much of a similarity with the situation in Japan in the 1990s and early 2000s.” That rings hollow now. Forward curves enable investors to travel through time. Inflation breakevens at five-years, five-years forward, which were stable, are falling rapidly.
“Turning Japanese?” was the question this column asked of Europe in March. If you look at the eurozone and Japanese breakeven curves the conclusion would be that transformation has already happened. Japanese-style debt deflation would be a disaster in Europe. No wonder then that Draghi followed his recent speech at Jackson Hole by quickly moving the ECB to adopt the supposed policy panacea the rest of the G4 has already plumped for: quantitative easing and large-scale asset purchases.
It might help. But the banking system in Europe also needs fixing. The credit multiplier is broken and deleveraging continues. RBS estimates that Europe’s banks have cut their lending to business by €561 billion since 2009. The US and UK economies are clearly healthier than the eurozone. Accelerating money supply growth also suggests their banking systems are healing, while in Europe monetary aggregates and credit availability remain depressed.
Against that backdrop the conclusion of the banking stress tests and the asset quality review are crucial. The ECB’s targeted longer-term refinancing operation (TLTRO) could also pump up to €300 billion into the eurozone economy by the end of the year and help the banks support credit starved businesses, particularly in the periphery. The stakes for Draghi and the EU could hardly be higher.
Currency matters
For most of the post-war period Italy was regarded as an economic miracle. Like most miracles Italy’s economic success was partly smoke and mirrors. In the days before the euro, a chronically weak currency and intermittent devaluations kept its exports competitive. These exports generally came from small or mid-sized businesses in sectors such as textiles, food processing and white goods.
The euro has taken away the devaluation option and globalization has made it harder for small-scale businesses to compete. Como’s silk producers have halved their workforce since the introduction of the single currency. QE, TLTRO and the policy prescription so far announced by the ECB is palliative medicine – it might maintain the status quo but offers little prospect of a full recovery.
Central bankers are being asked to do too much. During the height of the eurozone crisis in 2011 I had no doubt the currency union would survive, with or without Greece. But despite the prevailing calm and record low levels of borrowing costs in the core and periphery, the odds on eurozone survival are falling every day.
Debt, deflation, stagnant growth and shocking levels of unemployment are eroding democratic consent for the European project, as last May’s elections showed. Euro Eurobonds and fiscal transfers are needed. The European electorate, however, is deaf to the “more Europe” solution just when it is needed most. QE is not enough. “Whatever it takes” is not enough. Central bank action is not enough. The eurozone crisis may be in abeyance, but it is far from over.