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ECB Cannot Save Euro; Crisis Back With Vengeance?

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Edward Markus - founder, owner and chief analyst of ECR Research and ICC - is coauthor of this blog.

Austerity vs Growth

The focus in Europe is shifting from austerity towards a growth-led model. Central bank governors and fiscal authorities are more inclined to stimulate the economy. Even to the extent of allowing public debt to expand.

This changing mentality is caused by the following:

• Without higher growth rates, a vicious deflationary spiral can take hold.

• There are no signs that the period of low growth is about to end. Social and political tensions could continue to skyrocket. People have been promised "the earth" in the past, now they end up with empty hands.

• Baby boomers are due to retire. Ideally, younger workers should take over the baton. However, youth unemployment is shooting through the roofs. A "lost generation" can quickly lose many of the skills it has acquired and once growth finally recovers, we can expect severe bottlenecks.

No free lunch

In the past Europe could compensate for structural weaknesses by debt-fueled economic growth. First in the private sectors, later in the public sectors as well. Virtually everyone extrapolated high growth rates into the future. Not just private individuals and businesses took out credit on the basis of unrealistic expectations; social security systems were also built on assumptions that the boom would continue.

The credit crisis showed that it is impossible to accumulate huge amounts of debt with impunity. By now, many people do not want to borrow more. Especially as lower growth has caused asset prices to fall. Governments, too, have enormous budget deficits and national debts: they needed to bailout banks and in a climate of sluggish growth the tax take drops whereas more money needs to be spent on social benefits. To make matters worse, populations are graying. Consequently, public expenditure will continue to soar, a lower number of workers will have to support more and more jobless people and the elderly and will have to service outstanding debts.

Europe to overcome debt addiction?

It has become imperative to learn to live within one's means. Economies need to be reformed until they can compete with the rest of the world and start to grow faster, without the need for debt accumulation. The focus should be on making job markets more flexible, improving the investment climate, providing better training and education, and fostering R&D and innovation.

However, such measures cost a lot of money and will be at the expense of existing social security benefits. This meets with substantial political resistance. Moreover, this pain is immediately noticeable whereas positive results of structural reform will not be evident for years.

ECB to the rescue?

Therefore politicians find it very hard to implement the necessary measures. This is why they exert pressure on the ECB to ride to the rescue. The central bank has consistently stated it does not want to facilitate a policy that provides governments with an easy way out, instead of staying on budget and opting for restructuring.

But as the Eurozone has been in the doldrums, the ECB has to guard against deflation. As a result, interest rates are close to 0%. Which is one of the reasons that governments are not in a hurry to buckle their belts. Owing to the low interest rates, it is cheap to finance deficits.

Last week the central bank loosened monetary policy further as it implemented a quarter-point rate cut (from 0.75% to 0.50%). On top of this, banks can more easily borrow money from the ECB over a longer period.

No substitute for structural reforms

A less restrictive fiscal policy and monetary easing could put some upward pressure on growth but not to the extent that the Eurozone will really find its feet again. Any recovery will be temporary. The underlying causes of the euro crisis will not be remedied. The only real solution is far reaching reforms and additional steps towards a banking and fiscal union. Both are not (yet) politically feasible.

Less austere fiscal policy implies widening deficits. Unless economies restructure, public finances will deteriorate, which increases the chance of tensions between the Eurozone periphery and the core.
Under such conditions, investors will shift capital from the weak to the strong EMU countries or even to non-EMU areas. Following the Cyprus bailout, it is fairly obvious that the next bailout of a member state will force investors and large depositors to shoulder a far more substantial percentage of the costs.

All this implies European stock prices will fall in the coming months and increasing European tensions, on the back of slowing growth, fears that recent rallies do not chime with real economic developments and the idea taking hold that the ECB cannot save the euro on its own. The euro crisis will be grabbing headlines again before the year is over.