Europe’s unbalanced answer to weak growth

14/11/2014

This week we learnt that Europe can land a probe on a comet 510m kilometres away. What it cannot do, apparently, is pilot its wayward economy. While this has hitherto been of concern mainly to European countries themselves, other governments are beginning to lose patience.

The news that the eurozone’s gross domestic product rose 0.2 per cent in the third quarter after stalling in the second was unsurprising. Weakness is no longer confined to the peripheral economies: that Germany and France narrowly avoided recession was treated as glad tidings.

The eurozone’s problems, and the mistakes in policy exacerbating them, are familiar. An uncompetitive periphery, including Italy, the eurozone’s third-biggest economy, is attempting to deflate its way to competitiveness within a single currency with all the economic retrenchment that involves. The process is being made more painful by constrictive fiscal policy guided by budget rules that contrive to be both opaque and counter-productive.

Meanwhile, the core economies, particularly Germany, are failing to pick up the slack by increasing public investment or boosting domestic demand. Germany has set itself the arbitrary goal of balancing its federal budget next year, and has taken the recent weakness in its GDP as a reason to redouble its efforts. It is often said that Germany is a large country that acts like a small one – without regard for the impact of its actions on neighbours. In this case, it is behaving like a small country without regard for itself.

The eurozone’s inability to revive its economy is causing exasperation elsewhere. Jack Lew, US Treasury secretary, this week warned that excessive fiscal stringency in the eurozone and the possibility of an unwelcome tightening in Japan were likely to drag down global economic growth.

Because fiscal policy remains too restrictive, the European Central Bank has to work overtime to find new ways to ease. Tight fiscal policy with a loose monetary stance is a textbook formula for a depreciating currency: the euro has fallen nearly 10 per cent against the dollar since midyear.

Yet a weak currency cannot solve Europe’s problems on its own. Trade accounts for about a fifth of the eurozone economy. Realistically, its members cannot collectively become a large enough net exporter to outweigh weakness in domestic demand. More likely is a re-run of the “currency war” tension between 2010 and 2012 when the US was accused of deliberately weakening the dollar to gain competitive advantage. In 2011, Guido Mantega, Brazilian finance minister, accurately blamed the US Congress more than the Federal Reserve for the US’s policy incoherence, likening its tight-fiscal loose-monetary policy stance to a duck with a broken wing trying to fly.

This time the eurozone and Japan will be the villains, and the ECB and the Bank of Japan unfairly blamed for the foreign exchange byproduct of a monetary policy justified by domestic conditions. Just as the Fed was correct to try quantitative easing, the ECB and BoJ are right to push ahead with loosening policy further with outright purchases of financial assets. Neither central bank should be blamed because its fiscal counterpart is failing to do its bit.

This weekend, as the G20 leaders gather at their summit in Brisbane, they may wish to have a word with Angela Merkel, Germany’s chancellor, about her country’s wrong-headed approach. Fiscal delinquents in Europe must do their homework and reform but German intransigence risks becoming a bigger problem for the world economy too.

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