From the August 2012 issue of Investment Advisor • Subscribe!

Europe: What Now?

The region bought some time, but its future is still uncertain

Europe has avoided—for now—the drama of a Greek exit from the euro thanks to Greece electing a party that broadly backs its bailout terms. Europe has bought time in the face of crisis, but the same deep-rooted problems remain.

Europe buys more time

The Greek vote for New Democracy, the party most supportive of the bailout conditions, is an enormous relief for the region and the global economy. The alternative may have been Greece crashing out of the eurozone.

Although a Greek exit is still possible, the recent election somewhat lowers the risk in the short term. Athens has established a coalition, but Greece does not have a strong history of coalition politics. Furthermore, social unrest is already widespread and violent. An escalation in response to more austerity could be politically very destabilizing. Greece still has to negotiate its austerity plan with the European Union, the European Central Bank and the International Monetary Fund, and is due to reimburse 3.2 billion euros of its loans this month. If discussions are prolonged, the tightening squeeze on public finances will intensify.

Furthermore, the somewhat overshadowed outcome of French parliamentary elections—a resounding victory for Francois Hollande’s Socialists—should pave the way for calmer political waters as the pre-election political posturing subsides. Hollande’s anti-austerity positioning, at odds with Angela Merkel’s agenda, may still be damaging to progress in Europe, but a strong majority behind him in France should allow him room to maneuver internationally.

Hollande’s growth agenda has made some progress. The promotion of spending in infrastructure-related projects for the equivalent of a mere 1% of GDP is not a bad development, but lacks two things: size and speed of impact. Merkel wants to support growth in her own way, but she wants to do it through reforms that promote structural and sustainable growth. She also wants further political, fiscal and banking integration to force accountability and some level of control—a logical goal given the circumstances.

Break-up is too costly

Even if Greece leaves the single currency, we believe the cost of a full eurozone break-up is so high that Europe will muddle through. ING economists estimate a complete break-up would cost European countries at least 8% of GDP in the first year and tip the United States back into recession. This is likely to outweigh even the harshest medicine required to maintain the single currency.

For now, the region has bought time. But it must use this to take steps that do more than paper over cracks. Governments are in something of a bind: A low growth environment makes fiscal adjustment harder and more risky, but high debt stifles growth. The social unrest building in Greece and Spain, as well as the extremist parties gaining traction, warn of the political difficulty of pushing through severe austerity without measures to increase growth. The focus therefore needs to be on policies that increase the credibility of Europe’s commitment to reform, but which do not suppress demand in the short term.

Regaining competitiveness is key

In the longer term, the region needs to carve out its role in the “new normal” environment that is increasingly dominated by emerging markets, most importantly by regaining competitiveness. Europe is not alone in the developed world in becoming less competitive versus emerging markets, but the extent of its uncompetitiveness is stark.

The strength of the euro is a key part of the problem: Hourly wages in manufacturing are almost 40% higher in Germany than in the United States in dollar terms, but just 4% higher in terms of purchasing power parity.

In southern Europe, the problem is worse. Greece is woefully uncompetitive having experienced the single largest increase in unit labor cost since 2005 as a result of salaries growing over five times the pace of productivity gains. This should result in currency depreciation, but clearly this was not possible under a single currency. Although the euro has weakened in recent months, it has been remarkably resilient since 2007, and a softer euro should be welcomed.

For the monetary union to be truly successful, closer fiscal and political union is needed. This will be slow and challenging, but times of crisis can provide the conditions that make possible reforms that would otherwise be too difficult or contentious to achieve. Europe is in such a moment and must not waste its chance.

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