The EU’s imbalances and the harm they cause the US

The European economy is benefiting from some welcome news, but it is not out of the woods yet. More importantly, the same things that threaten European economic performance could do harm to the United States.

The good news is more than just political. The election of French President Emmanuel Macron has brought an end to the unwelcome prospect that Marine Le Pen would try to take France out of the eurozone.

{mosads}Not many people expected Le Pen to win, of course, but recent experience with the British referendum on European Union membership and the U.S. presidential elections have taught Europeans to expect the unexpected. The fact that Macron’s victory comes on the heels of a defeat for the extreme right in the Netherlands only adds to the sense of relief.

The economic data is also improving. European output growth is consistent, retail spending is increasing and unemployment is nudging downward. There are big differences across countries and regions. Germany is doing much better than Italy, for example. Nevertheless, the consensus among market observers is that the recovery is gaining momentum.

European Central Bank President Mario Draghi is not ready to start taking away the punchbowl — i.e., returning to a less-accommodative monetary policy — but some of his colleagues on the ECB’s Governing Council are pointing in that direction. Even the inflation data, which has long been stuck well below the ECB’s target, is starting to show signs of acceleration.

Nevertheless, there is caution in the markets. Macron’s election did not spark a huge rally. The glass-half-full community says this is because the markets already priced in a Macron victory. The half-empty group points out that Macron still needs to win the legislative elections in June if he is to govern the country effectively.

The Dutch are in a similar situation. They may have held the extreme right out of government but that is not the same as creating a cohesive governing coalition. Moreover, neither Le Pen nor the Dutch extremist Geert Wilders are going to disappear. If Macron and his Dutch counterparts fail to take advantage of their victories, the implicit threat that voters will support unpleasant alternatives will come back with a vengeance.

In the meantime, market participants are turning their attention to Italy. The good news is that former Prime Minister Matteo Renzi has won back control over his Democratic Party (PD). The more challenging news is that Renzi had to sacrifice the PD’s chances at forming an outright majority to reassert leadership. Worse, Renzi cannot build a majority to agree on how to reform the country’s electoral system.

This creates the risk that Italy will head to the polls with a system that translates seats into votes on a roughly proportional basis. There is little threat that the radical Five Star Movement will take over the country in such a situation, but it is easy to see how Italy’s parliament could dissolve into bickering ineffectiveness. Given how much Italy needs to reform its banks, labor markets and government finances, a fractious parliament is going to hammer down confidence and drive away investment.

This is where Europe starts to have an impact on the United States. Two factors are important: One is the strong support in Germany for export-led growth and fiscal consolidation; the other is the desire among Europeans to find a haven for their assets that offers a positive rate of return. These two factors are tangled together in a problem of macroeconomic imbalances.

Europe’s economies are not only sending their merchandise to the United States (and Great Britain) but also their savings. The positive trade balance is sure to attract the attention of the Trump administration. The impact of capital flows on the strength of the dollar and the upward pressure on U.S. asset prices is arguably more damaging. American competitiveness is more likely to be damaged by currency movements and financial market fragility than by any act of European trade policy.

Europe’s macroeconomic imbalance is also bad for Europe. The flow of capital from countries like Germany to countries like Italy during the 1990s and early 2000s is what set the stage for the crisis that followed. Germany had to bail out its banks and Italy got to watch its economy collapse once those flows reversed and German investors tried to get their money back.

Now that pattern is repeating, both across Europe and between Europe and the outside world. The big difference is that now market participants know how the system works. They will be quicker to cut exposure than they were in the past.

There is good news in Europe but also reason for caution. Europeans need to consolidate the gains they have made. The U.S. interest is to help them in that effort because a failure in Europe would have a big impact on the United States.

Erik Jones is the professor of European studies and international political economy and the director of European and Eurasian studies at Johns Hopkins University.

The views expressed by contributors are their own and not the views of The Hill.