The Eurozone[1] has received a bad economic press in 2014, with concerns over its sluggish growth rates, the risk of deflation and skepticism over the ability of its policymakers to address its structural ills all contributing to negative market sentiment at various points throughout the year.
This year has certainly been a disappointing one for the region, in economic terms. While the vast majority of European economies returned to positive growth during 2013, raising expectations that the recovery was becoming more broad-based and self-sustaining, gross domestic product (GDP) growth struggled to gain momentum during the first half of 2014. Confidence indicators have fallen since mid-year and are now back at their end-2013 levels, while hard economic data have been persistently weak. Growth appears to have been held back by a number of factors, including deleveraging pressures and a slow pace of structural and institutional reform.
Can the Eurozone defy its critics and produce a robust recovery in 2015? On paper, domestic demand in the region should increasingly benefit from very accommodative monetary policy, with European Central Bank (ECB) interest rates at floor levels and new asset-purchase programs in place. These should improve the supply of credit. Alongside monetary stimulus, however, the Eurozone’s strategy – driven by Germany – consists of structural reforms and fiscal discipline. Both France and Italy are being encouraged to accelerate the first of these structural reforms to reignite growth in their lagging economies. Since they generate nearly 40% of activity in the region, their success would provide a substantial boost to the Eurozone overall.
Germany has a point. Its own ‘Hartz reforms’[2], introduced from 2003-05, are often cited as a factor behind the country’s improved labor-market performance. Germany’s unemployment rate is currently 4.9%, less than half the average rate in the Eurozone (11.5%). In addition, the post-crisis experience of both Ireland and Spain suggests that countries willing to swallow unpalatable reform medicine – including cuts in nominal pay, pension and other welfare provisions – can achieve stronger rates of economic growth. While the Eurozone overall stalled in the second quarter of 2014, Spain’s economy expanded by a healthy 0.6% and Ireland’s by an eye-catching 1.5%.
But can these economies really teach the Eurozone’s laggards a lesson? Ireland may have closed the ‘double Irish’ loophole that allowed U.S. companies to reduce their tax bills, but their strategy essentially remains one of competing on the basis of a low corporation tax rate; almost by definition, it is not an approach that all Eurozone countries can (or would be able to) adopt. Spain’s reforms have been pushed through by a government with a clear electoral mandate, a starting point of relative strength. The political backdrop in both France and Italy is complex and potentially more fragile. And while Germany’s reforms may have improved its labor-market performance, they have not created dynamic demand. A contraction in GDP of 0.2% in the second quarter of 2014 may have been partly due to temporary factors, but Germany’s domestic demand has expanded at a compound annual rate of only 1% in the past decade, as it has become increasingly reliant on demand from overseas to generate headline growth.
So while some of the Eurozone’s biggest players may need to undertake structural reforms, these alone will not generate stronger growth for their economies or the region as a whole. Indeed, structural reforms have a patchy record of success. Some countries have undertaken such reforms with mixed success (like Germany); some have made painful changes but ultimately appear to have benefited (like Ireland and Spain); while those who may need to reform the most appear unwilling to (Italy and France). The rationale for structural reforms is clear cut, but the outcomes and degree of political appetite for them are much less so. The weaker euro, continued monetary stimulus and a healthier global backdrop may help avoid deflation, but 2015 looks likely to be another year of sluggish recovery for the Eurozone.
[1] Eurozone refers to the bloc of nations that has adopted the euro as common currency and legal tender.
[2] The Hartz reforms constitute active and passive German labor market policies.
Lucy O’Carroll is Chief Economist – Investment Solutions at Aberdeen Asset Management