Europe: political opportunity amid systemic threats

Brooks MacDonald

The eurozone is undergoing an economic recovery, with unemployment falling and the threat of deflation mitigating amid rising global inflationary forces. However, this masks uneven levels of progress being made by the region’s underlying countries. With some of the stronger economies’ business cycles maturing, there remains significant risk that the recovery will stagnate if growth in the weaker economies fails to accelerate. Structurally lower productivity growth, adverse demographics and generally high private and government debt levels remain secular headwinds across the region.

The German economy, by far the eurozone’s largest, remains strong, with unemployment at multi-decade lows and economic activity expanding. However, its economic cycle is maturing and although steady, its growth rate is unspectacular. Encouragingly, the Spanish economy appears to be undergoing a robust recovery amid an expansion in credit lending, export growth and with employment falling from extremely elevated levels. However, the French economy is struggling to improve as bureaucracy and high taxes are weighing on job creation. Likewise, the Italian economy continues to be held back by its stricken banking sector, which is proving unable to facilitate credit creation and hence economic activity.

There are a number of major political events occurring across the eurozone in 2017. France elects its next president in April and Italian Prime Minister Matteo Renzi’s recent resignation means that Italy is also likely to hold a general election at some point in 2017. Meanwhile, Holland and Germany are also due to elect their next governments in March and by October 2017, respectively. These events hold the potential to allow incoming administrations to implement much-needed reforms in Italy and France, but even if these occur they will take some time. Certain key situations could be politically difficult to resolve given European Union (EU) rules, such as the recapitalisation of Italy’s banking sector. However, if the right policy solutions are found they could provide catalysts for growth to accelerate; for example, by allowing France to reduce its persistently high unemployment rate, or by allowing credit growth to accelerate in Italy.

More troublingly, if anti-establishment political parties gain power they could push for referenda on their countries’ EU memberships. These could catalyse secessions from the currency bloc which could potentially lead to its demise. However, we are cognisant that polls show most Europeans would vote to remain within the EU. Indeed, Austria’s recent election provided a litmus test of sentiment towards the politico-economic union on the Continent and ultimately its electorate voted to maintain their incumbent pro-European government (by a fairly heavy margin, given pre-election expectations). Nevertheless, if markets judge the possibility of the eurozone disintegrating as rising, economic and investor confidence will likely be heavily, and rapidly, damaged with wide-ranging consequences. We note that Greece’s situation also remains an ongoing issue, albeit of lesser impact given that its problems have been widely acknowledged for a number of years and that it holds relatively limited importance to the broader eurozone economy.

Despite the many political risks, the European Central Bank (ECB) continues to focus on its mandate targets of employment and inflation. With unemployment remaining elevated and inflation subdued, the eurozone’s central bank recently decided to extend its quantitative easing programme until the end of December 2017, or beyond if necessary. However, it also decided to reduce the value of its monthly asset purchases from April as near-term deflationary threats have diminished.

This article was first published by Brookes MacDonald in December 2016.