With France, Italy, Spain in turmoil, ECB cannot prop up euro zone economy alone

The European Central Bank (ECB) headquarters is pictured in Frankfurt, Germany, September 3, 2015.
Ralph Orlowski | Reuters
The European Central Bank (ECB) headquarters is pictured in Frankfurt, Germany, September 3, 2015.

Successful economic stabilization programs require coordinated fiscal, monetary and structural policies. But the current state of affairs in the euro area is such that this basic axiom of economic policy is unlikely to be met anytime soon.

Half of the monetary union (i.e., France, Italy and Spain) shows serious backsliding from earlier politically and socially flammable efforts to conform to the German diktat of austerity policies, or its oxymoronic sequel of "austerity growth models."

France (one-fifth of the euro area) is leading this group of backsliders. Its budget deficit this year is expected to exceed the last year's shortfall of 3.9 percent of GDP. French security and military operations at home, in the Middle East and in North and Central Africa are likely to widen the budget gap toward 5 percent of GDP.

War budgets

But ever eager to outmaneuver their stern Teutonic lecturers, the French recently got the euro area's (tacit?) agreement that the "security pact" should replace Germany's much-maligned "stability pact." That implies that any public spending related to security and military operations should not be counted toward the monetary union's (a.k.a Maastricht's) budget deficit rules.

It appears that the French extracted that concession because the Germans, along with other euro area members, were not eager to join France in fighting the Islamic State in the Middle East and Africa.

Indeed, after a considerable soul-searching, Germans – with half of their fighter jets grounded for lack of maintenance and spare parts – have reluctantly decided to send some of their airplanes to do intelligence gathering in Syria, and a navy frigate to escort the French naval battle group off the Syrian coast.

Italy - with a budget deficit of 3 percent of GDP and a staggering public debt of 160 percent of GDP - is also facing a worsening fiscal outlook. In addition to a large spending for public services and tighter security measures for the Holy Year of Mercy that starts tomorrow and runs until November 20, 2016, Italy may soon have to get involved in a chaos-ridden Libya (its former colony). The Islamic State has been conducting military operations in Libya for some time, and it appears to have branched out to Tunisia and Egypt.

There are no indications as yet that Spain is about to join any of the terror-fighting coalitions. At the moment, the Spanish government has its hands full with the forthcoming general election, to be held on December 20, 2015.

Whatever the electoral outcome, the new government is likely to continue its current "go-slow" fiscal consolidation. It would be unrealistic to expect anything else in a country beset by a crushing unemployment rate (21.6 percent in September), with nearly half of its jobless youth facing a bleak future. But the narrowing of the budget gap of 4.5-5.0 percent of GDP must continue in order to halt and then reverse the growth of an unsustainable, and growing, public debt of 119 percent of GDP.

That is the fiscal picture the ECB is looking at. The ECB, therefore, cannot expect any help from the fiscal policy to lift the euro area's private sector credit demand. And yet, that's what is needed to speed up the economic recovery through rising household consumption spending, residential investments and business capital outlays.

The situation is quite similar with regard to euro area's structural reforms.

Flexible labor markets

These reforms are highly charged political issues. They go to the core of Europe's societal values and of the sacrosanct institutions of the welfare state – a real minefield for elected officials of any political stripe who might wish to challenge them. That is how important this issue is, even in cases where structural changes could increase the economic efficiency by cutting corruption and waste.

But, by accident or design, the term of structural reforms in the euro area has been narrowed to giving greater freedom to firms to hire and fire the labor force, based on the idea that this would lead to lower unemployment rates.

Now, ask the French how effective that has been. That large euro area country continues to experience rising unemployment in spite of a laissez-faire labor market, where most of the new employment contracts are for temporary or part-time jobs. The main culprit, of course, is a moribund economy rather than any remaining labor market rigidities.

Just like France, Italy has also managed to introduce similar reforms.

Spain, however, has done them one better in terms of temporary and part-time jobs and informal labor markets. Some would call that a dubious distinction because that has created a new class of working poor. These are the people with monthly salaries of 1,000 euros or less ("mileuristas" in the vernacular) who can barely get by or have to go back to live with their parents.

Two weeks from now, voters seem poised to sanction the "neoliberales" (almost a dirty word for right-wing politicians) who followed the German script of spending cuts and labor market flexibility. The Spain's right-of-center party in power (polling at about 26 percent) is neck-and-neck with its main competitor, the Socialist Party, while the extreme left Podemos (Yes, We Can) is edging up close to 20 percent of the popular vote.

In France, the governing Socialists are in for an even greater drubbing. Opinion polls for the first round of French regional elections forecast a punishing vote for the coalition government of leftist parties and for the disoriented right-of-center politicians. Rising unemployment and home-grown terrorism are expected to give a big win to the right-wing Front National.

Italy's government, led by a tough-talking prime minister, looks safe for now, but competition from various left and right political formations continues to gain ground.

Investment thoughts

Budget deficits and public debt in half of the euro area are set to increase as a result of security and military spending in France and Italy, and a moderate pace of fiscal consolidation in Spain. Structural policies aiming at greater labor market flexibility have largely run their course.

Spain's imminent general elections, regional and general elections in France and a fluid political landscape in Italy create major uncertainties for these countries' economic policies and growth outlook.

Working against that economic and political background, and the euro's weak exchange rate, the ECB correctly decided last Thursday to roughly maintain the current degree of monetary easing, because the existing volume of liquidity continues to gain traction with the real economy. The rate of growth of the broad monetary aggregate, M3, is increasing, and so are the rates of growth of bank lending to households and non-financial corporations.

The ECB is doing a good job. But there is nothing the ECB can do about the euro area fiscal and structural policies, the intractable migrant crisis, growing security problems and an apparently terminal discord in a part of Europe that was supposed to be united in peace and fraternity.