Economics, International economy

Time for an economic Plan B in Europe

Image Credit: Shutterstock

Image Credit: Shutterstock

Despite the European Central Bank’s periodic assurances to the contrary, all is not well in Europe. As this morning’s dismal second quarter European GDP numbers confirm, the European economic recovery that began last year has simply run out of steam. It has done so  as its three largest economies–Germany, France, and Italy–have all moved ever closer to a triple-dip economic recession. As a result, six years after the onset of the Great Economic Recession, Europe is yet to regain its pre-2008 output peak putting Europe well on its way to a lost economic decade.

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The fact that Europe’s economic recovery has run out of steam should have come as no surprise to European policymakers. This is especially the case considering Europe’s restrictive economic policy setting, the poor state of its banking system, and the still very strong Euro. Most of the countries in the euro zone are still engaged in meaningful fiscal adjustment within a Euro straitjacket that constitutes a major headwind to economic recovery. At the same time, the fact that Europe lags well behind the United States in addressing its banking sector problems has led to a situation where the European banks are still cutting credit to the private sector. As if that were not enough to abort an economic recovery, until very recently a strong euro has dented European export prospects.

Despite Mario Draghi’s brave pronouncements on the European economic outlook, there would seem to be every prospect that the European economy will weaken further in the months immediately ahead. After all, the policy setting remains largely unchanged and the high frequency economic data are suggesting that geopolitical uncertainty around Ukraine and the Middle-East is exerting a larger than anticipated adverse effect on the European economy in general and on the German economy in particular. There is little reason to expect that this geopolitical uncertainty will dissipate anytime soon. At the same time, it would seem highly unlikely that the modest monetary policy measures adopted by the ECB at end-June will do very much to offset the strong headwinds now confronting the European economic recovery.

One of the more disturbing aspects of the European sovereign debt crisis has been the tendency of European policymakers to engage in wishful thinking and to remain in denial. Indeed, throughout the crisis they have been blindsided by events and they have clung to the hope that something will turn-up that will finally put the European economic recovery on a firmer footing. Sadly, they seem to be again engaging in such wishful thinking as they underestimate the very real damage that deflation can do to a highly indebted economy and as they continue to underestimate the combined negative effect of budget austerity and an ongoing credit crunch on the European economic recovery

 With inflation now running at around one quarter of the ECB’s inflation target and with large gaps still characterizing the European labor and product markets, it is difficult to understand why the ECB is delaying a more aggressive and proactive response to Europe’s very real deflation risk. By the same token, considering that a policy recipe of budget austerity and economic structural reform has not delivered a meaningful European economic recovery, it is difficult to understand why European policymakers are so resistant to rethinking their basic approach to the European sovereign debt crisis.

 Hopefully the recent stream of negative economic data coming out of Europe will shake European policymakers out of their present state of complacency. For if it does not, we should brace ourselves for very rough going in the global financial markets when the US Federal Reserve starts the process of normalizing interest rates.

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