Monetary union without fiscal cohesion is recipe for trouble

THREE MONTHS AGO, European leaders had just concluded yet another summit at which emergency measures to save the single currency were front and centre of discussions. The euro crisis was raging and the economies of the developed world appeared to be heading back into recession.

Europe was in the worst shape, as the sovereign debt/financial crisis began affecting the real economy via the banking system. A full-blown credit crunch seemed to be in the offing.

The intensification of the crisis since the summer came on top of a slowdown in the real economy (to which the crisis undoubtedly contributed). In the second and third quarters of last year, euro zone GDP growth had slowed to a spluttering 0.1 per cent quarter on quarter. In the final three months of 2011, the bloc’s economy contracted for the first time since emerging from the Great Recession in 2009.

There has been considerable change in the three months since that summit. The debt/financial crisis has been in abeyance – the longest spell in more than a year that the Continent has not been on the brink of meltdown.

The pumping of more than €1 trillion in medium-term lending into the banking system by the ECB is almost certainly the reason for a calming of the crisis. It has been vital in buying time.

The €1 trillion lent to banks at an interest rate of just 1 per cent over three years is a money-making machine for financial institutions, as they use it to buy government debt yielding multiples of what they are paying in interest.

Although there are no shortage of questionable issues surrounding the exercise, the upsides have been a lowering of sovereign financing costs and a recapitalisation by stealth of the banking system (via the profits made on the trade).

Also of significance over the past three months has been the finalisation of the fiscal compact, initially agreed at the December summit, and a permanent bailout mechanism which is to be put in place within months.

The agreement reached last week with Greece’s creditors to write off the largest chunk of sovereign debt in history removes that source of uncertainty, for a while at least.

There are many moving parts to the crisis, including the need for further and bigger changes to the single currency’s institutional architecture and the possibility of additional bailouts for already bailed-out countries (including Ireland).

But underpinning everything is the need to reduce debt levels, which have been shown to be unsustainable. Doing that (without further defaults) will be all but impossible without economic growth.

The point of public debt unsustainability has already been passed in Greece, leading to last week’s record default of sovereign debt. It is far from certain that other countries – including Ireland, Italy, Portugal and Spain – can avoid going down the same route.

As the first quarter of the year moves to a close, how is Europe’s real economy faring?

A range of the most timely monthly economic series, including hard data and survey indicators, gives reason to believe that the slide in evidence in the second half of last year has been halted.

Retails sales across the bloc rose in January after heading south for most of the second half of 2011; industrial production ticked up slightly in the new year following falls in three of the final four months of last year; the European Commission’s various confidence surveys showed consumers and investors to be a little more upbeat in the early months of 2012 than in the closing months of last year; and the Markit composite indicator of economic activity was higher in January and February than at its low point in December.

That is the good news. The bad news is that the European economy has dipped to a point where there does not appear to be enough momentum to generate growth in 2012. According to the Economist magazine’s monthly poll of 20 private-sector forecasters, none believes the euro zone will expand this year. The most optimistic outlook is for a marginal decline in GDP of 0.1 per cent.

As described below, the euro zone’s national economies have had very different experiences since the world changed in 2008. The trends over the past four years are reflected in more recent developments.

Germany’s domestic economy was still growing in the final quarter of 2011 even if its GDP declined slightly. France, along with Finland and Slovenia, was the only reporting economy not to suffer a contraction in GDP in the final quarter of last year.

The French economy – the second largest in the euro after Germany – is critically important. Its triple-A credit rating was cut by one of the three agencies earlier this year. Another downgrade would undermine the collective creditworthiness of the entire euro zone. That France continues to grow when most other euro area economies are in or flirting with recession offers hope that that fate can be avoided.

Germany and France together account for half of the euro zone economy. But even if they avoid recession and continue to expand, they are are unlikely to generate enough forward thrust to drag the weaker economies back to growth.

And as long as the euro zone remains a monetary union without a fiscal union, it will be only as strong as its weakest link.

There are many weak links. Italy is the biggest, if not the weakest. Having suffered two consecutive quarters of GDP contraction (the most common definition of recession), it is on the slide. A fall of 0.7 per cent in the fourth quarter and indicators in the new year point to a deep recession in 2012.

If anything Spain looks worse. In the final quarter, it suffered a huge decline in domestic demand of 1.8 per cent in just three months. With unemployment already at 23 per cent, output contractions of that kind for another couple of quarters would sent Spain into the sort of tailspin Greece has already experienced.

Europe is nowhere near to being out of the woods yet.