Eurozone: In Need of Re-Adjustment

25.07.2017

In recent periods optimism with respect to the prospects of Europe’s economic development appears to have been rekindled as signs of higher economic growth, a strong recovery in the euro in global markets and moderation in political tensions gained momentum. Notwithstanding these positive signs financial market participants continue to sound alarm bells with respect to the lingering fragilities observed in the Eurozone. In particular, the Bank of America Merrill Lynch declared recently that despite the efforts of France and Germany to act together in supporting the euro, there remain significant divides between the well-off and the poor regions of the Eurozone that imperil the integrity of the unified currency. In view of the geopolitical landscape in which the Eurozone finds itself, such concerns may be valid after all.

Indeed, changes in US foreign policy with respect to Europe imply less trade and investment liberalization as well as the likelihood of more defense spending. While it is still unclear as to how much of a long-term change this change is for Europe, the adverse implications for Europe in the coming years are likely to be represented by lower pace of structural change and greater fiscal pressures.  

All of this comes on top of the challenges posed to Europe by migration issues, which are likely to continue to loom large as long as geopolitics in the Middle East continues to be in crisis mode. The issue continues to be among the most divisive in Europe, both within states and across European countries. Even the Scandinavian economies that have achieved relative success in integrating significant parts of migration inflows into the labour market are not immune from tensions occasionally resurfacing in the public debate on the costs of migration.  

Add all of the above together and the fiscal bill of financing elevated spending on migration, defense and the need to plug the holes in the social security system arising from adverse demographics translate into substantial challenges on this fiscal front. The latter are already quite formidable as significant parts of Europe (particularly, Europe’s South) have undertaken large-scale fiscal cuts (most notably in the social sphere), which lowers the scope for further fiscal conservatism.

Another issue facing the Eurozone is the recent strength in the euro – while a positive sign in itself, if the trend towards exchange rate appreciation persists, it may undermine Europe’s competitiveness and stifle economic growth. Against the backdrop of mounting protectionism in the world economy the sensitivity of changes in market shares (both within and outside of EU) to lower competitiveness is likely to rise.           

But the most important challenge facing the Eurozone compared to the above headwinds is the divergence in the economic structure and income levels across Eurozone’s members, particularly between the North and the South. These gaps will continue to exert redistributive pressures within the EU, which will continue to feed the political debate within Europe’s donors on the expediency of transfers to the South. Being lenient with respect to some of the borrowers in Southern Europe or with regard to countries that missed the macroeconomic stability criteria of the Eurozone (Portugal and Spain being the latest cases in point) risks creating precedents that undermine the commitment of borrowers to stay the course in fiscal restraint.

This leads the discussion into the future paths of Eurozone’s development. On the domestic front Macron is right in calling for greater integration in the EU’s fiscal sphere – this is so far the greatest source of economic divergence and tension. Without greater integration in the fiscal area the EU may continue to experience tremors along the North-South divide. On the external front the re-adjustment in the face of lower engagement from the US will need to focus on the East – including via participation in China’s OBOR initiative as well as through a full-fledged recognition of the Eurasian Economic Union and the rebuilding of economic ties with Russia.
Views expressed are of individual Members and Contributors, rather than the Club's, unless explicitly stated otherwise.

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