All too many reasons for pessimism about Europe

It was said of the House of Bourbon that they forgot nothing and they learnt nothing. One has to wonder whether the same might not be said of the European policymaking establishment. For as Europe looks set to slide into a triple-dip economic recession, most European policymakers stick to the mantra that a policy prescription of fiscal austerity and structural reform will in the end turn the European economy around. And as Europe’s politics continue to fragment at an accelerating pace, they cling to the hope that the wave of populism now gripping Europe is but a passing phase. Sadly, this does not bode well for Europe’s economic and political outlook. Since without a major and early change in economic policy direction, there is little reason to believe that either the European economy will pick up or that its political deterioration will be arrested.

By now, one would have thought that European policymakers would have given up on the notion that fiscal austerity in the middle of a recession and within a Euro straitjacket that precluded devaluation was a good idea. After all, despite the hope at the start of the year for a solid economic rebound, all the indicators now point to a renewed stalling of the European economy. Disturbingly, this leaves the European economy meaningfully below its pre-2008 peak some six years after the onset of the global economic recession. Equally disturbing is the fact that a feeble European economy is now being hit by a new external shock in the form of an escalating cycle of sanctions and counter-sanctions associated with Russia’s standoff with the West over Ukraine. That standoff must be expected to continue undermining European investor and household confidence.

{mosads}To his credit, seemingly alone among Europe’s leading policymakers, Mario Draghi, the European Central Bank (ECB) president, recognizes the need for an urgent change in policy direction. At the end of August, in an important speech at the Jackson Hole Economic Policy Symposium, he emphasized that Europe needed a coordinated policy approach to its economic problems that included an easier fiscal policy stance, a faster pace of structural economic reform and unorthodox monetary policy measures. However, no sooner had he tabled his policy proposal than Wolfgang Schauble, Germany’s powerful finance minister, made it quite clear that Germany did not see the need for any change in policy from its current direction.

Sticking to the failed policies of the past is particularly unfortunate at this stage of the European economic cycle. Europe as a whole is now on the cusp of price deflation, while the highly indebted countries of the European economic periphery are already experiencing outright price deflation. If Europe’s deflationary tendencies take root, it is difficult to see how the highly indebted countries of the periphery will be able to restore public debt sustainability. It is also difficult to see how Europe will not be exposed to another and more virulent round of its sovereign debt crisis once the U.S. Federal Reserve starts hiking interest rates and once global liquidity conditions are not as favorable as they are today.

Equally disturbing is the all-too-likely further deterioration in Europe’s political landscape should its economy continue to languish. Since the onset of the European debt crisis in early 2010, the European public has progressively lost faith in its political elite in response to years of economic recession, budget austerity and high unemployment. This has spawned the emergence of extremist parties on both the left and the right of the political spectrum, from Greece to Spain and from Portugal to Italy. It has also given rise to a veritable backlash against sticking to a policy recipe of budget austerity and structural economic reform.

It has to be of the deepest concern that Europe’s political fragmentation has not been confined to its periphery. Indeed, the most troubling recent political developments have to be those in France and Germany. In France, Francois Hollande has now lost control of the Senate, which has to throw into question his political ability to reinvigorate the French economy. This is especially the case with Marine Le Pen’s National Front Party breathing down his neck. Meanwhile in Germany, the rapid rise of the Alternative for German Party (AFD) is bound to limit Chancellor Angela Merkel’s room for policy maneuver. This is particularly the case with respect to her scope for adopting an easier fiscal stance or for giving the green light to the ECB to go ahead with full-bodied quantitative easing.

One has to hope that European policymakers soon wake up to the real threat of a dangerous economic and political downward spiral in the eurozone. Since if they do not change their policy course soon, they might find that Europe will have reached the point of no return and that the euro will be beyond saving.

Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.