The Eurozone crisis: Here comes the summer…

For many investors, the maxim of ’sell in May and go away’ is prudent strategy to deal with the traditional summer lull in stock markets. Despite the pain that is being felt in the real economy of the Eurozone, things have been relatively fruitful of late for investors. In fact, the strong performance of financial markets has been fêted by many as a sign that the pain in the Eurozone is subsiding.

However, financial markets normally begin to pick up once the worst of a crisis has been experienced. The general public, on the other hand can only consider a slowdown over once employment and wages return to pre-crisis levels. It has become clear that the previous growth in the Eurozone was unsustainable. Significant reforms must be undertaken – both to all of the member states and the Euro itself.

Initially, though, the threat of collapse had to be dealt with. Perhaps the most successful policy to this end was the Mario Draghi’s pledge last year that the limitless resources of the European Central Bank would be used in order to save the currency. Any speculators looking to gain from betting against the Euro realised that it would be impossible to win in such a one-sided fight, and market tension subsided.

This pledge should have been taken as a bold move to buy time to undertake badly needed structural reform, rather than a solution to solve the crisis in itself. Instead the harsh austerity imposed upon peripheral economies in order to boost confidence in the viability of the Eurozone continued, despite the confidence problem being solved by the ECB.

The move towards austerity was rash for several reasons. For a start, markets can often exhibit excessive optimism or pessimism. The temporary euphoria at the idea of some action being taken will eventually give way to panic when it appears that important systemic issues have still not been resolved. The confidence that QE and Draghi’s pledge managed to foster could be damaged, possibly making it self-defeating for European officials to prioritise reassuring markets over everything else.

Imposing fiscal consolidation also causes both political and social unrest, lessening the possibility of much needed changes, especially to the labour market, being pushed through. Politicians have and continue to find it hard to sell the concept of reform when most of the other ideas put forward by European officials have caused so much pain.

Furthermore, the pace of the policy of austerity is regarded as excessive, and it has repeatedly been shown that cutting fast does not work. In ’Globalisation and its discontents’, Joseph Stiglitz suggests: ’The effects of a recession are long lasting… the deeper the recession today, not only is output lower today, but the lower output is likely for years to come’.

Proponents of deficit cutting were right to note that the use of the standard Keynesian approach would be complicated by weak banks and highly indebted firms; but simply strangling growth exacerbates the problem. The severe credit crunch being experienced by firms in Southern Europe would suggest that any notion of a recovery seems unlikely, given that the same problems of 5 years ago are still alive. It has become increasingly clear just how much these remedies have ’killed the patient’.

What is required more than anything is collective action. The aforementioned push for deficit reduction is a case in point. Euro officials seemed to overlook the fact that contractionary policies imposed in one country will have a spillover effect to others when this is not the case. In Germany at the start of the last decade, cutting (when the world economy was relatively more buoyant) proved effective. When most Eurozone countries started to reduce deficits during an economic slowdown in the Western World, the result was disastrous.

It is clear that the economies of the periphery need to undertake reform, but any collective action must also include Germany. The European Commission last week urged Germany to foster wage growth. A potential reversal from the excessive wage restraint of the last decade; which proved not to be conducive to domestic demand and helped increase imbalances within the Eurozone, highlighting its structural faults.

The increasing divergence that resulted between the two groups within the Eurozone can be bridged by both sides, but it appears that the German government does not see it that way. Norbert Barthle, budget spokesman for Chancellor Merkel’s Christian Democrats, suggested to a British newspaper in April that ’Sovereign debt is the foundation of this crisis in Europe. It is a mistake to retreat from [the] policy of consolidation.’

Germany also urges other countries to boost their productivity, much like it did in its transformation at the start of the decade, but this idea is misconceived. In a publication for the Centre for European Policy Studies, Daniel Gros suggested that the reforms in Germany in fact had no impact on productivity, indeed that ’all available data shows that Germany had one of the lowest productivity growth rates over the last ten years.’ He concludes that the reduction in labour costs is almost entirely due to wage restraint.

Overseeing similar restraint in the periphery countries now will be more difficult as wages then were only restrained relative to a time of strong economic growth. At the moment wages are rising slowly (and in most cases falling in real terms) in almost every Eurozone country.

Ideas such as a banking union have been mooted as part of the solution, but as has been the case on a number of issues, talks have become bogged down on a number of technicalities. More recently, it has been suggested that two of the great economic stimuli of the twentieth century should be resurrected in different guises. The prospect of a ’New Deal’, this time on youth unemployment, was put forward at a conference a few weeks ago. Per Steinbruck has also suggested a ’new Marshall Plan’ to help save the periphery from ’joblessness and economic stagnation’. These ideas are still in development mode, but at least the pace of fiscal retrenchment is slowing.

For the key players in the Eurozone often the need to simply avoid a meltdown has been enough of a reason for a short-term outlook. Sadly for them, the passage of time has not resolved the issues that have belied the strength of the Euro for many years. Indeed, it is this problem that has most worried investors about a potential future without QE. Now that the summer lull approaches, leaders can have no more excuses as to why the long-term steps are not being taken.

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