The Eurozone Crisis hasn't Gone Away.

By David Bailey on Dec 30, 12 10:14 PM in

Contrary to what many people seem to think, the Eurozone crisis hasn't gone away. After the dismal affair that was the Autumn Statement last month, a view seemed to take hold in parts of the media at least that the Eurozone countries were getting on top of their problems and that faster European growth would boost British exports and with them the UK economy. Sadly that's not the case.

Of course, as I've pointed out before, poor performance in the Eurozone is not the cause of double dip recession in the UK and an at best flatlining economy, as George Osborne has tried to claim.

Rather, that has been down to his inept handling of economic policy combined with the lack of a meaningful growth strategy. Nevertheless, the Eurozone hasn't helped. The Eurozone is the destination for 50% of UK exports. So when it's in crisis many British businesses feel it especially.

The problem is that the Eurozone has essentially entrenched austerity in Europe. The Eurozone is suffering from an acute shortage of aggregate demand made worse by a rush into austerity by Eurozone countries.

Economies like Germany which have the fiscal room for manoeuvre could and should stimulate their economies to encourage consumption and boost growth across the zone. That isn't happening, in part because the institutional make-up of the Euro doesn't enable it.

A particular problem centres on the fact that the periphery has seen its competitiveness blunted by its inability to devalue. For years Italy for example simply depreciated the Lira to remain competitive and enjoyed decent growth and a trade balance.

Since the Eurozone was created Italy has not been able to do this and has steadily lost competitiveness. The same goes for much of the Eurozone periphery.

Meanwhile the core countries including Germany and the Netherlands have enjoyed a huge boost in their competitiveness. Previously their currencies would have appreciated on the back of export surpluses, but under the euro their currencies have been fixed, so they have stacked up big competitiveness gains and have run huge current account surpluses (in Germany's case as high as 6% of GDP and for the Netherlands as much as 10%).

The previous exchange rate appreciation would have kept current account surpluses in Germany down (and in so doing kept inflation down hence allowing real incomes to rise and the possibility of more consumption spending).

The flipside would have been that Italy would have depreciated its currency, retained competitiveness, and exported more to the likes of Germany. Such self-correcting mechanisms across structurally quite different economies no longer exist, with the effect of huge imbalances building up.

Another effect of an appreciating D-Mark under the old system would also have been pressure on the German government to relax fiscal policy to boost growth domestically, given that an appreciating currency would have made German exports more expensive.

Under the euro there is no such pressure to act. In fact, Germany feels obliged to teach the 'profligate' periphery the virtues of fiscal responsibility and the whole Eurozone gets mired further in an austerity quagmire.

Rather than a 'Growth and Stability Pact', Europe essentially has a 'No-Growth and Austerity Pact'. That in turn weakens an already fragile banking system which continues to retrench its lending, especially to small firms. And unemployment continues to rise across the Eurozone.

For the Eurozone to continue in a way that enables growth then ultimately it will need a new pro-growth Pact along with a single fiscal policy with transfers to the periphery to offset the ongoing loss of competitiveness they are experiencing under the euro (along with supply side reforms to try to boost competitiveness there). That doesn't seem very likely. But neither does a break up of the Eurozone (that could instead enable peripheral countries to devalue their currencies and kick start growth)

Take your pick. Or see a chronic lack of aggregate demand along with huge imbalances continue to drag the Eurozone into prolonged recession.

Professor David Bailey works at Coventry University Business School

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