European economy

How well is Europe's economy doing? Following the European sovereign debt crisis and the Brexit (British exit from the European Union), are we about to witness a deepening European crisis fueled by structural issues? Or is it the case, as I heard several European institutional investors say, that European equities are the most promising assets to invest in because Europe is on the track to recovery and its market is undervalued compared to other regions in the World? For example, Igor de Mack, fund manager and spokesperson at DNCA Investments, said in a recent comment that "low valuations [of European equities] are increasingly compelling"

Youngster carrying the European flag at the World Youth Days in Krakow, Polonia

First let's look at the latest economic figures for the Eurozone.

1. A double-dip recession

GDP growth shows the Eurozone suffered a double-dip recession, the first part being in 2008-2009, triggered by the global financial crisis, and the second part in 2012-2013, an idiosynchratic event called the European debt crisis. The fact that the USA didn't suffer the second dip is really interesting, because it shows that the Eurozone economy faces specific issues, and is therefore more vulnerable than other regions.

2. A strong current account balance

The current account balance, which is defined as the difference between a nation’s savings and its investment, turned significantly positive (3.7% of GDP), as a result of improvements in the balance of trade. This apparent good news - it indicates that the Euro area is a net lender to the rest of the World - may actually be not so good if you try to understand the reasons. Indeed, an excessive current account balance may indicate that the Euro currency is undervalued. I can see two possible explanations for this relative weakness of the Euro currency: (1) an extremely accomodative monetary policy by the ECB and (2) perceived risks to the future of the EU and/or Eurozone. In summary, the European economy could be benefiting in the short term from its weakness in the long run.

3. Improvements in the labour market

Let's now turn to the labour market. Unemployment is at 10.1% (June 2016), declining at a pace of 1% avery 18 months. If we consider that the lowest unemployment rate of the last 20 years was slightly above 7% in 2008, and infer that this is the structural unemployment rate of the eurozone, then we will reach this threshold in January 2021 if the pace of decline stays steady. Is it optimistic? According to my computations since 1970, average business cycles length is 8.5 years for the World and 8.75 years for the USA. Projecting this average cycle length to the current business cycle that saw a low in 2009, this means we could see a new low as early as 2018 and that the USA may already be on the declining part of the business cycle. A recession in the USA would surely impact the Eurozone, and as a result, the latter would not be able to reach its structural unemployment level.

4. Monetary policy reached the zero lower bound

The European Central Bank's benchmark rate reached 0% (also called the zero lower band) and it embarked on a Quantitative Easing program to further support the financing of the economy. This means that the ECB is as supportive to the economy as it can be. Should a shock happen, for example  through the business cycle theory developed in paragraph 3,  then the eurozone's economy would be hit without any cushion.

5. High level of debt

Having just escaped the European debt crisis - where the market was distrusting the bonds issued by the governments of Greece, Ireland and Portugal - , it is natural that we should look at the levels of government debt in the Euro area. Government debt reached a peak of 92% of GDP in 2014 and is now slowly declining. Can we expect this (recent) improvement to continue? To decrease the debt to GDP ratio, one needs to have either GDP growing (aka a healthy economic growth) or fiscal consolidation (aka the government paying down its debt) or both.

6. The failings of the Maastricht treaty

In a realm where there is a common currency but 19 different fiscal policies, the architects of the Maastricht treaty had designed a set of rules to keep the Eurozone together: a Stability and Growth Pact, which should limit the amount of borrowing each country is allowed, and a non-bailout clause, to prevent a country from being bailed out by other countries. As explained by Jean Tirole in his book Économie du bien commun [1], none of these rules has been enforced: the pact has been violated 68 times, including by the biggest countries Germany and France as early as 2003 (only 4 years after the creation of the Euro!!) and Greece has been bailed-out by other Eurozone countries. Not only did this situation weaken the credibility of the European Commission and the European system as a whole, but it has also created a free-riding type incentive for countries to let loose their budget deficits because they know that the burden will be shared and diluted across the currency area. So is it a case of a good system being badly implemented and should we blame the people who didn't enforce the rules correctly?

This view is what Jean-Claude Trichet used to say when he was at the head of the European Central Bank. Unfortunately, the fault lays on the Maastricht treaty itself, because it created what economists call a non-optimal currency area and created a flawed governance framework. Rules were not enforced not because of bad will but because they were simply not enforceable. For example, the responsibility for enforcing the Stability and Growth Pact lays on the finance ministers of the member countries. Since each minister represents his or her country, it is sometimes seen as the best strategy for a minister not to blame his counterpart who has breached the rule hoping that the latter will pay back this "generous" behavior in the future, when the former risks breaching the rule himself. Furthermore, the punishment for excessive deficit being to impose a fee on the country at fault, it would make the situation worse for a country in a difficult fiscal situation and we understand that the council of finance ministers has therefore never done it.

Regarding the non bail-out clause, it is very difficult to enforce because there is a short term - long term trade-off. In the short-term, it is beneficial to bail out a country because the cost of the bailout (often as low as just committing to help when need be) is much lower than the risk of contagion. But in the long term, countries will adopt a much more fiscally responsible policy if they know that they won't be bailed out.

Because the European institutions have lost credibility in enforcing fiscal rigor, it would be very optimistic to expect debt to carry on decreasing in a sustainable way.

7. Monnet's error

As explained by Guiso, Sapienza and Zingales [2], the European Union was designed by politicians like Frenchman Jean Monnet who envisionned a federalist union like the United States of America as an ultimate goal, but proposed a step-by-step approach in order to built up support on the way and prove that their project was realistic. What is strange is how this was implemented:

The functionalist view, advanced by Jean Monnet, assumes that moving some policy functions to the supranational level will create pressure for more integration through both positive feedback loops (as voters realize the benefits of integrating some functions and will want to integrate more) and negative ones (as partial integration leads to inconsistences that force further integration). In the functionalists’ view integration is the result of a democratic process, but the product of an enlightened elite’s effort. In its desire to push forward the European agenda, this élite accept to make unsustainable integration steps, in the hope that future crises will force further integration.

This functionalist view helps to understand the failings of the Maastricht treaty: the failings were designed to built up support for more integration. However, this approach has failed because support for European institutions has decreased after each of the two major European projects: Maastricht treaty in 1992 and European enlargement in 2004. A resounding illustration is the referendum in the United Kingdom which was lost by the pro-EU camp this year.

          Evolution of positive sentiments about membership in European Union (E.U. 15), Source: Guiso et al

Europe is now trapped in a catch-22 situation: there is no desire to go backward, no interest in going forward, but it is economically unsustainable to stay still.

8. Conclusion

To conclude, the Eurozone seems to be trapped in a low growth momentum, vulnerable to both external or internal negative shocks. The Euro currency could appreciate if the risks don't materialize but excessive debt will probably be a problem for years to come.

[1] Jean Tirole, Économie du bien commun (May 2016), PUF

[2] Guiso, Luigi and Sapienza, Paola and Zingales, Luigi, Monnet's Error? (April 2015). CEPR Discussion Paper No. DP10559