Steinbock: Euro Zone Adrift: Failed Austerity, Wrong Course

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Since 2010, Europe's decline has accelerated. Even a benign and incremental scenario suggests that, between 1980 and 2017, Europe's share is likely to plunge from more than 32 percent to less than 20 percent of the world economy.

The worst days of the euro zone crisis are not behind but ahead—and here are the reasons why.

How Austerity Policy Failed

Before Christmas 2012, Europe's commissioner for economic and monetary affairs, Olli Rehn, announced that the worst of the euro zone crisis was over. In turn, European Commission president, Jose Mario Barroso, declared that "the perception of risk in the euro zone has disappeared."

During the past four months, Brussels has continued to urge the European Union leaders to stay the course on debt reduction and economic overhauls, even though these policies have failed across Europe. Unemployment has soared to 12.1 percent, while inflation has plunged to 1.2 percent, a three-year low.

Until recently, Brussels supported front-load austerity measures with little regard for growth and employment. In the U.S., President Herbert Hoover tried similar policies in the 1930s, when they contributed to the transition from a severe recession into the devastating Great Depression. Since 2010, Europe has followed in the footprints.

The fleeting confidence of the European leaders rested on the one policy that was not their making: the European Central Bank's liquidity injections.

In July 2012, ECB President Mario Draghi pledged to do "whatever it takes" to preserve the euro. Since last September, the rhetoric has been supported by Outright Monetary Transactions (OMT), a program to offer liquidity to sovereign debt markets in the periphery. The unintended consequence has been a huge political moral hazard.

Draghi's liquidity shots were designed to boost the euro economies and thus to serve as a catalyst for accelerated political integration. In practice, the colossal liquidity shots have created a de facto dependency. Monetary policies cannot heal fiscal cracks.

Why Growth Won't Replace Austerity

"We're witnessing the end of the dogma of austerity," French Finance Minister Pierre Moscovici said recently.

In reality, governments do not create prosperity, markets do. And in the euro zone, the "muddle through" approach has virtually ensured that markets cannot realize their full economic potential.

Real growth policies would require Paris to reform job protection, strengthen active labor market policies, and continue to reduce the minimum cost of labor. The Socialists could also reduce regulatory barriers to competition and improve the quality and efficiency of tertiary education.

The socialist government of Francoise Holland is not about to unleash a massive experiment in pro-growth policies. Rather, the Elysee Palace is lobbying for a two-year extension, to meet the EU deficit rules. Such efforts are about deferring both austerity and growth.

France is amidst a prolonged contraction. Driven by fiscal consolidation, growth will remain below zero percent in 2013, on an annualized basis. At best, Paris can hope that quarterly growth will remain close to zero percent in the second half of the year and close to zero in 2014. The French contraction is not only driven by fiscal retrenchment, but by plunging industrial production, business and consumer confidence, coupled with a softening external sector.

Even if Paris would get another year to meet its 3 percent budget deficit target, stagnation will force new austerity demands—which, in turn, are likely to keep Paris in its austerity trap, fragment the socialists, and foster instability.

The Too-Big-to-Fail Domino Effect

Between 2010 and 2011, the euro zone challenges were restricted to small economies (Greece, Ireland, Portugal, even Cyprus), which each individually account for less than 3 percent of the euro zone gross domestic product. As a result, the region's challenges could be contained.

Everything changed in late 2011, when the risks arrived in both Spain and Italy. The two account for almost 30 percent of the regional GDP. The two are simply too-big-to-fail.

Last fall, German Chancellor Angela Merkel and French President Francois Hollande concluded that Spain and Italy desperately need time to get their economic houses in order. If, under these circumstances, Greece would default, it would have a contagion effect across Europe. Consequently, Merkel and Hollande felt that they would have to support Greece for another two years.

Along with Brussels, Merkel and Hollande presumed that the reforms by Mario Monti's technocratic regime would gain the broad blessing in Italy's spring elections. In reality, nine of 10 voted against Monti's austerity policies. What's worse, the political field fragmented to Pier Luigi Bersani's center-left (30 percent), Berlusconi's center-right (29 percent), and comedian Beppe Grillo's anti-establishment coalition (26 percent).

Led by Enrico Letta, Rome's new centrist government represents old veterans, not new reformers. A gridlock is likely to prevail over the political system, which will stall the reform program. In the process, Italy's GDP, which has now fallen for seven consecutive times, may contract on a quarterly basis until the year-end of 2013.

In Spain, the aggressive austerity measures of the Mariano Rajoy government have contributed to the plunge of investment, consumption and government spending. In a benign scenario, the erosion will eventually force Madrid to seek official support.

Here's the net effect: As France is deteriorating, Italy has potential to fall into a more vicious trap, which will be compounded by missed fiscal targets and contraction.

While Italy and Spain have been temporarily insulated from Greece, Italy cannot be isolated from Spain. And what happens in Spain will not stay in Spain. If Madrid turns to Brussels for help, Italy is likely to follow.

Toward Crisis Escalation in 2013-2014

In Germany, economic expansion is reliant on growth in the U.S. and China. If U.S. is swept by another debt crisis in the summer, or if Chinese growth prospects slow down more, the resilience of German exporters will deteriorate.

Politically, Germany is already divided as Chancellor Merkel's conservative CDU and the social-democratic SDP are split between austerity and growth policies. Meanwhile, the support of critical, alternative euro-skeptic voices is increasing. Even in the most benign scenario, German growth will remain around 0.2 percent to 0.5 percent in the remaining quarters and close to zero growth through 2014.

Ultimately, the European sovereign debt crisis can only be overcome with both fiscal consolidation and pro-growth policies. In the absence of significant policy shifts, the current austerity approach will lead to a steep cliff by 2014—but not across that cliff.

Europe's unemployed youth will not sit still for a lost decade. It despairs for hope. In the absence of dramatic policy shifts, the euro zone crisis has potential to escalate dramatically in the coming months.

Dr. Dan Steinbock is research director of International Business at India China and America Institute (USA) and Visiting Fellow at Shanghai Institutes for International Studies (China) and the EU Center (Singapore).

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