The “sick man” of Europe may very well be all of Europe. Since the Great Recession of 2008-2009, growth has been generally slow and painful, and the danger of prolonged stagnation in Europe is a very real possibility. The euro has dropped to its lowest value in nine years. With Europe accounting for 25% of global trade, its recovery is imperative to the health of the global economy. The forecast for 2015 is looking dismal, only marginally better than 2014.
“Frankly, it’s very hard to be optimistic about Europe. There are lots of issues,” says Mauro Guillén, Wharton management professor and director of The Lauder Institute. The continent is facing a “deceleration of the German economy. Southern Europe is not working as it was supposed to and there are lingering problems with high unemployment and high taxes,” Guillén adds.
Unless there is a decisive change in structural, fiscal and monetary policies, Europe may continue to languish in the upcoming year, according to the Organisation for Economic Co-Operation and Development (OECD). “Europe is at the center of weakness in the global economy,” says Catherine L. Mann, the OECD’s chief economist. The institution forecasts growth in the eurozone to be just 1.4% in 2015. That’s an improvement over the low 0.7% for 2014, but it’s well below what Europe should be achieving.
Last year, the overall world economic growth rate stood at 3.1%. And Mann points out that the global rate is still below the 4% average between 1995 and 2007. She explains that with the burgeoning sizes of “faster-growing emerging economies, world GDP should be expanding faster — not slower — than past norms. Investment and trade globally have yet to pick up to full steam.”
Mario Draghi, president of the European Central Bank (ECB), has announced that he is preparing to change course to resuscitate the eurozone’s “fragile and uneven” economic recovery, possibly with quantitative easing measures, a strategy that Europe has previously shied away from. Since the last half of 2014, the ECB has “adopted a variety of measures to stimulate bank lending. The real question is how far can they go and how effective will it be,” says Joao F. Gomes, a Wharton finance professor.
By having several countries drastically reduce their deficits all at the same time, growth was undercut and the adjustment has been incredibly painful. It’s a Catch-22, notes Olivier Chatain, strategy and business policy professor at HEC business school in Paris and senior fellow at Wharton’s Mack Institute for Innovation Management.
“Frankly, it’s very hard to be optimistic about Europe. There are lots of issues.” –Mauro Guillen
“Low inflation and deflation are becoming major problems,” Chatain notes. The inflation rate has “been very far below the European Central Bank’s 2% target for a very long time, which makes debt consolidation much more difficult.” Inflation has stayed precariously low, hovering at 0.3%. Spain and Greece have actually been in deflation, a trend that could spread to the rest of Europe.
Unemployment in Europe, with the exception of the U.K., is in the double digits and not forecast to drop until 2016. According to Mann, “Consumer spending and investment have consistently failed to pick up, leaving Europe with high unemployment and weak tax revenues.” On the positive side, Chatain points out that “the activity rate of adults who can work is actually much better now — as good as it in the U.S. — than it was in the 1990s.”
However, within Europe, countries with very different personalities are contributing to an unsteady recovery effort that is affecting the entire continent.
The Greece Drama
One of the first and foremost countries to set the tone in Europe for 2015 is Greece, which has been among the countries that have been hardest hit by the crisis. The OECD predicts Greek unemployment will continue to hover around 25% until 2016, even after the IMF forecast that Greece’s unemployment rate would reach no higher than 15% when bailout programs were first put in place in May 2010. Household incomes have fallen by one third and public debt has exceeded more than 175% of Greece’s GDP. Governments like Greece ran big deficits and lived off borrowing from the outside world, notes Gomes.
Following a tense drama where Parliament failed to agree on a president in three rounds of voting, Greeks will now go to the polls for an early election on January 25. What’s at stake is how the country will adhere to the current austerity regime. “The idea behind the austerity policies is to create sustainable growth, but it’s a painful, long process. At least the next five years will be extremely painful,” explains Guillén. Greece’s opposition political party, Syriza, is quickly gaining momentum and campaigning on a platform to renegotiate the budgetary guidelines imposed by the “troika” — the European Commission, the ECB and the IMF. “Greece has improved but the elections are complicated and adding external concerns,” says Gomes.
When the debt of countries like Greece and Spain began to spiral out of control at the beginning of the global recession, there was speculation that the eurozone might fall apart. Draghi vowed to keep the member countries from defaulting. But talk about Greece leaving the eurozone is starting to bubble up again.
In the current situation, Chatain explains the “key underlying issue is that the current debt level is too high and that debt still needs to be further restructured. The only question is whether this happens within the eurozone or outside, and sooner or later. Syriza, if elected, wants restructuring within the eurozone.” However, other countries, like Germany, may not want to permit restructuring and may very well allow Greece to leave the eurozone,” adds Chatain. German Chancellor Angela Merkel’s spokesperson had to calm the waters this week following reports that top German authorities now see a Greek exit from the euro as a manageable risk. The spokesperson said Merkel’s position continues to support stabilization of the eurozone without any members dropping out. But speculation was nevertheless rampant that Merkel has come around to the view that a Greek exit from the eurozone (“Grexit”) would not be a catastrophic blow to the system.
While Greece’s financial tremors aren’t sending giant quakes to the European markets yet, the worry is that the political repercussions could rattle other EU countries and jeopardize a eurozone-mandated chance of a Greek revival.
“I think the real issue [for Greece] is the extent of the political contagion.” –Franklin Allen
“I think the real issue here is the extent of the political contagion,” notes Franklin Allen, Wharton finance professor and executive director of the Brevan Howard Centre at Imperial College in London. “If Syriza wins and manages to renegotiate, then it will lead to parties in other countries doing the same thing. If it is unable to negotiate and decides to leave the euro and defaults instead, then how it does so will be crucial to what other countries do going forward. If it does well, then other countries may do the same thing. If it does poorly in relative terms, then other countries obviously will stay put.”
Russia at a Crossroads
The Russian Federation caused chaos in the European markets with the Ukrainian conflict, and oil prices have plummeted in a plunging spiral. Investors and consumers are jittery that Russia will not scrape its way out of a recession. Since European and U.S. sanctions began at the start of August, the rouble has depreciated by 25%. As one of the largest importers of Russian oil and an important trading partner, Europe has been greatly affected by Russia’s decisions. “An unstable Russia will destabilize Europe. It’s a big energy supplier for European companies. The confrontations and sanctions add uncertainty and apprehension to the markets,” notes Guillén.
No one knows exactly how things will all pan out in 2015. President Vladimir Putin could dig his heels in against Europe and the United States, or he could make some moves to stabilize the Russian economy, which will in turn help businesses feel more confident about investing in Europe. “It’s very difficult to forecast what will happen with Putin. My own view is that he won’t give in to sanctions and will push harder in Ukraine and elsewhere to extend Russian influence,” says Allen.
In a recent report, European Union officials said that the sanctions “could pose a larger roadblock to European growth prospects than currently envisaged in the forecast,” according to The New York Times. Germany, Poland and other neighboring countries are exposed to Russia. If there was an economic collapse of the Russian economy, the growth in Europe is too slow to absorb the impact without consequences, notes Gomes.
The Slowdown of a Stalwart?
On the other end of the spectrum, stalwart Germany is still the driving engine in the European Union, though its current 1% growth rate is far from turbo-boosting the rest of the continent. Germany is also imposing harsh constraints on its European trading partners, while maintaining the world’s largest trade surplus. “We need rebalancing of trade and financial flux within the EU. This requires more inflation in exporting countries,” says Chatain.
“Europe has serious problems with demographics. Encouraging population growth and the current generation to work a little longer is important.” –Joao F. Gomes
In addition, the country isn’t investing very much in infrastructure. While Germany is the only economy that investors trust to make good on its promises, the German government also doesn’t “want to engage in as much stimulus as the [U.S.] Federal Reserve has. They want to be more conservative,” adds Guillén.
In France, receipts were less than expected, mostly because inflation was almost zero instead of the projected 1%, says Chatain. Reforms to deregulate in small sectors of the economy are actually underway but not as fast as the ECB would like for France to meet its 3% budget deficit target, Chatain adds. Next year, the OECD forecasts growth in France to be 0.8%, an improvement from 2014’s 0.4% figure.
Meanwhile, in countries like Spain, Italy and Portugal, tax rates remain extremely high, which discourages people from living there, much less working there, notes Gomes. On top of that, geopolitical weaknesses are affecting the economic recovery. Though Spain is expected to stay on track for a continued 2% growth rate, the country is facing some political unrest with the Catalonia secession question. The country’s 24% unemployment rate is expected to decrease as exports improve in 2015, according to the OECD.
Portugal is facing elections with pressure from far-right factions that want to close borders and limit immigration. These developments will affect the longer-term economic recovery for Europe, Gomes says. “Europe has serious problems with demographics. Encouraging population growth and the current generation to work a little longer is important.”
One bright spot has been the U.K., which has been one of the fastest growing economies in the Group of Seven countries (Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States.) Its strong recovery is expected to continue into 2015. The unemployment rate has been dropping steadily and is expected to reach 5.6% in 2015, according to the OECD. Consumer spending and investment have helped boost the economy. However, there are upcoming elections in May with the ruling Tory party under pressure by far-right political parties. Britain is vulnerable to downward drag if the rest of Europe, its biggest trading partner, doesn’t start showing signs of resuscitation.
New Year’s Resolutions
The economic outlook for Europe appears frighteningly similar to the way 2014 has panned out. Businesses may still be a bit reticent at pumping in investment. “There’s too much on the plate for next year” with political turmoil, high unemployment, low inflation and policy challenges, says Gomes. The geopolitical arena is raising questions with Russia as the wild card, and leadership elections loom large in Greece, Portugal and Britain, which could put a spanner in the works. Far-right factions are increasing influence in many countries, touching the nerves of citizens weary of their governments bowing to the wishes of central European policymakers. The European economic and political situation is leaving little wiggle room for missteps, and dimming hopes for a strong European recovery in 2015. Guillén adds, “Europe is facing enormous problems, and it’s very difficult to be optimistic.”