Europe Is Out of Economic Ammunition

The continent’s four biggest economies are all teetering. When they fall, they could take the world with them.
February 10, 2020
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Even before the coronavirus outbreak, troubles have been coming to the European economy not as single spies but in battalions. Worse yet, these troubles have come at a time when the European Central Bank (ECB) is running out of monetary policy ammunition and the German government remains wedded to a balanced budget policy. None of this bodes well for the European economy in the year ahead – or, for that matter, the global economy.

At the beginning of 2020, all four of the European economy’s  largest economies—Germany, France, the United Kingdom, and Italy—were beset by striking economic or political difficulties. As a result, in the last quarter of 2019, the overall European economy expanded by barely 0.1 percent, with France and Italy registering negative growth rates.

Unfortunately, with the fallout from the coronavirus epidemic about to hit the global economy, there is little reason to believe that the economic or political difficulties besetting Europe’s main economies will clear up any time soon.

Indeed, the slowing Chinese economy is likely to continue to hamper the export-oriented Germany economy. With the coronavirus projected to reduce Chinese economic growth from 6 percent in 2019 to around 4 percent in the first half of 2020, Germany’s economy is bound to take a hit. At the same time, the Trump administration’s continued threat to impose a 25 percent tariff on European automobiles is expected to continue weighing on Germany’s automobile sector.

Over the past year, President Macron’s waning political fortune and widespread social unrest triggered by his unpopular economic reform agenda have weighed down France’s economic performance. With President Macron showing no sign of backing down on his deeply unpopular pension reform initiative, an early turnaround in the French economy seems unlikely.

Since the June 2016 referendum, Brexit has not been kind to the British economy. As investors fretted about the possibility that the U.K. could crash out of Europe without an economic deal, Britain’s economic performance lagged well behind its G-7 peers. By the end of 2019, the U.K. was on the verge of an economic recession.

While the U.K. did leave Europe on January 31, it still has to negotiate a permanent economic relationship with the European Union during the one-year transition period that ends in December. Judging by Boris Johnson’s hardline Brexit position and by his insistence that the U.K. will not seek an extension in the negotiation period, investors are bound to continue worrying about the U.K. crashing out of the European Union at the end of the year.

Most troubling of all is Italy’s poor economic outlook. Italy has the dubious distinction of having a lower per capita income today than it did 20 years ago. It also has Europe’s second-highest public-debt-to-GDP ratio after Greece and a not-so-stable government. This makes its economy particularly exposed to any further slowing in the European and Chinese economies. With the Italian economy yet once again contracting towards the end of last year, one cannot rule out a recurrence of the Italian sovereign debt crisis in 2020.

European policymakers have compounded earlier European economic downturns by the pursuit of a pro-cyclical fiscal policy. With the German government insisting on maintaining a balanced budget and with the European Commission insisting that countries comply with the Eurozone’s budget deficit limits, there is little reason to think that European policymakers will use budget policy to counter the next European economic downturn.

The likely lack of a fiscal policy response will again put the full burden of supporting an ailing European economy on the ECB. However, with policy interest rates already in negative territory, the ECB can’t be as effective in jumpstarting the European economy as it was during the last Eurozone sovereign debt crisis.

With Europe’s economy being approximately the same size as that of the United States, another European economic slowdown would have a major effect on the global economy. American economic policymakers would ignore the current risks to the European economy at their peril. But, with trillion-dollar deficits as far as the eye can see and already-low interest rates, it doesn’t seem that the Fed and the Treasury have more room for maneuver than their European counterparts.

Desmond Lachman

Desmond 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.