Europe is struggling economically and politically in a way that its leaders had hoped was behind it. The momentum of earlier in 2014 has largely disappeared. No one can be certain of the path from here, so I offer three potential scenarios that broadly reflect the range of potential outcomes.
Scenario 1: It was just a glitch (20% probability?)
This is the optimistic outlook. It assumes that the underlying situation is better than the recently reported numbers, that reforms are slowly taking hold, and that the scare of the last few months spurs fresh actions to stimulate the European economies and undertake further necessary reforms. There is certainly an argument that the statistics may have understated actual performance, since economic data is frequently revised significantly over time. Further, random geo-political factors, such as the situation in Ukraine, clearly depressed activity. The recently agreed energy pact between Russia and Ukraine could help reverse this, if it sticks.
The European Union (EU), the Eurozone, and individual nations have put in place many more reforms than they are generally given credit for. Yes, there is much more that could and should be done, but that should not obscure the reforms that have been accomplished. The cumulative effects are significant and rising. One big step forward is the beginning of the Banking Union, which takes effect in a few days with the takeover by the European Central Bank (ECB) of supervision of most of the banking system in the Eurozone and some other EU countries. This was preceded by an Asset Quality Review and stress tests on the major banks to ensure that they were in acceptable shape as they enter the Banking Union. These tests showed quite positive results, with fairly modest capital raising required. Hopefully, the clean test results and the ECB’s new role will help break the vicious circle that has linked the health of banks and their sovereigns, with trouble on each side instigating or reinforcing problems in the other.
The recent negative economic reports, and fears of worse to come, have jolted European decision makers out of a complacency, or exhaustion, that had led to a slowdown in new reforms and in the implementation of old ones. The healthy new fear also appears to have opened up room for more government spending, or a slower rate of reduction in it, and more aggressive monetary policy. Germany is finally experiencing problems and this may render remedies feasible that were previously blocked by a German public that did not see need for urgent action. Do not expect truly dramatic changes in either the pace of reforms or the level of stimulus, but significant positive movement seems possible.
This scenario assumes that the underlying public unhappiness does not express itself in any national political crises. A pick-up in growth, even a modest one, would tend to reduce this possibility anyway.
Scenario 2: The Euro Crisis is Back (probability 10%?)
The pessimistic outlook is easy to lay out, but luckily not as likely. In this future, we discover that Europe’s problems were not seriously tackled over the last few years and that problems were only papered over. Markets had gone from overly pessimistic to overly optimistic. The resulting improved financing environment for European sovereigns and banks aided their situations considerably while also appearing to validate European reform strategies. President Draghi’s promise that the ECB would do whatever was necessary to hold the Euro together was worth a lot less than it appeared. Yes, the Euro held together, but the entire zone started to sink into another recession and a period of deflation. Deflation is particularly problematic, because it makes debt levels rise in inflation-adjusted terms, and renders it difficult to decrease real wages in over-priced sectors, since outright reductions in paychecks are harder to push through than simply failing to have pay raises match inflation.
The ECB has serious limitations on its ability to act, including the practical necessity for German acquiescence for aggressive actions such as Quantitative Easing. In this scenario, the ECB continues to be unable or unwilling to take the major steps necessary to ensure that inflation stays above zero (it has been below the ECB’s target of 2% for a long time now and has been creeping down). Its credibility, and therefore ability to act aggressively, could be further damaged by banks running into major problems early next year, despite having passed the ECB’s tests. One of the dangers of giving the ECB bank supervisory responsibilities is that mistakes in that area, which are quite possible, could blow through much of the stock of credibility built up by the ECB over the course of its decade or so of existence.
If monetary stimulus hits its limits, it is unlikely to receive much support from fiscal stimulus. Germany, the largest and in many ways strongest economy, has a population firmly opposed to increasing deficits. Few other nations in Europe have much room for fiscal stimulus given their high debt levels. Those that need such stimulus most could trigger strongly adverse market reactions if budget deficits accelerate the increase in their ratios of debt to Gross Domestic Product that are already raised by minimal or negative growth.
Structural reforms could prove to be politically impossible, and some might even be reversed, in the face of a wave of popular anger if the elites seem unable to pull Europe out of the multi-year crisis and instead seem to be guiding the region into another, possibly extended, recession.
It is easy to tick off any number of external problems that could make all this much worse, ranging from a worsened Chinese slowdown to a pullback in the American or Japanese economies and any number of geopolitical problems that could arise, with Ukraine at the top of most people’s lists, but with problems in Iran or the Middle East also very possible.
These factors are all worrisome and there is a distinct possibility of a European slide into recession and deflation. I put the probability as low as I do because Europe has real underlying strengths and much has been done to correct the problems that helped lead to the current situation. Further, the ECB appears determined to find new ways to push growth forward, in conjunction with national governments, if the situation deteriorates further. The trickiest part will be finding the combination of fiscal and monetary policies that will lift growth for the medium to long-term to acceptable levels.
The national political environment across Europe is likely to be very troublesome in this scenario, partially because the problems may be created by such turmoil and partially because a nosedive may snap the surprisingly patient response of voters to date. (There have been rejections of national governments, but the real surprise so far has been how much voters have been willing to accept painful changes without complete revolt.)
Scenario 3: The Usual Muddling Through (70% probability?)
The greater likelihood appears to be a version of what we saw over the course of the Euro Crisis. European leaders, including the ECB, will do just enough to maintain some overall growth in the region, but will find it politically impossible to take the steps to really break out of the near-stagnation, at least over the next several years. With good luck, growth might rise to 1% annually for the region as a whole over that period. With bad luck it might fall to near zero. Europe has had difficulty staying focused on reforms once the pressure comes off, which limits the ability to redesign its economy to break out. At the same time, the pressure of near-recession and near-deflation steel European backbones and force steps forward, despite political pain.
Europe has many strengths, including a well-educated workforce that could thrive in an increasingly high tech era. The region will eventually find the will to reshape itself for the future, but it may take some years for the reality to sink in that the status quo is not working satisfactorily and that there is no way to simply retreat to the good old days. There is a great deal of popular anger in Europe, but most of it is geared to defending past deals and privileges, (such as labor protections, professional prerogatives, and cushy government jobs) and not towards finding the new way forward.
The political situation in this middle ground scenario is difficult to judge. My guess would be that voters in many nations continue to support the broad course of European reform, although grumpily, while a few stage nations more of a revolt against their current leaderships. A key question will be the response of French voters. Virtually everyone outside of France agrees that the nation needs to take stronger steps to correct its problems, but so far the French voters do not agree, or differ so much on the type of change that reforms remain blocked.