Financial market optimism ran well ahead of the fundamentals for the eurozone in 2013. A recovery finally started but was weak and, even in countries making progress on the reform side, spare capacity and supply side improvements do not guarantee the recovery will accelerate strongly in 2014-15.
Demand in the eurozone, in contrast to the UK, seems set to remain weak. High unemployment and GDP that is still 3 per cent below pre-crisis levels show the slack in the real economy. But while productivity gains in Spain, Ireland and Portugal are increasingly evident, key adjustments are now needed in larger states such as France and Italy – and serious labour or product-market reforms do not look imminent in either.
The European Central Bank (ECB) has eased policy but has faced difficulty getting it to feed through into the real economy.
While productivity gains in Spain, Ireland and Portugal are increasingly evident, key adjustments are now needed in larger states such as France and Italy
The first step towards banking union will occur in 2014 with the asset-quality review and stress tests before the ECB becomes the single banking supervisor this autumn. The aim is to restore trust in cross-border lending, but without a single supervisory mechanism that has a genuine financial backdrop, it will fail to sever the link between the banks and sovereigns.
That means fragmentation will persist with credit growth continuing to contract in 2014 with only a few exceptions. This is bound to keep the recovery in domestic investment and consumption weak.
Ireland has graduated from its Troika programme but still has more fiscal consolidation to do, as have Portugal and Greece. But France and Spain must also act to meet their fiscal targets. Even Germany’s additional spending – just 0.8 per cent of GDP – will be spread over four years and the national minimum wage will not start until 2015, with full implementation from 2017.
So fiscal policies will provide only little and gradual help in rebalancing the eurozone and the growth outlook still largely hinges on global demand at a time when world trade growth is expected remain below pre-crisis levels.
The ECB could try to do more to support demand given the very low rates of inflation. It cut interest rates in November 2013 in its quest for price stability and could seriously consider negative deposit rates in 2014 while further boosting long-term liquidity. But such measures are unlikely to be very effective and could have negative side effects. They are, however, less controversial than the outright quantitative easing (QE) that might eventually be needed if growth and inflation projections for 2016 and beyond continue to be cut.
The medium to long-term prognosis for the eurozone has hardly altered. Our 2014 growth forecast is unchanged at 0.8 per cent (well below the ECB’s 1.1 per cent) when we now expect 2.6 per cent for the UK. Even next year we see eurozone growth at just 1 per cent (compared with the ECB’s forecast of 1.5 per cent) and inflation still nearer 1 per cent than the targeted 2 per cent. That will make it yet harder to stabilise government debt burdens.
So the eurozone looks set to continue ‘muddling through’ in 2014 with growth just positive enough to prevent a new fiscal crisis but not strong enough to significantly ease the debt problems. It will be a year when inflation is very low, but not low enough for the ECB to resort to QE. And a year when governments, under no serious pressure from markets, can avoid big decisions about how much sovereignty they are truly willing to relinquish as part of future eurozone integration.
This research was first published on 17 December 2013.