Cause and Effect in European Politics and Law

Euro Area, Good and Bad Recession

Adelina Marini, August 15, 2014

In the second quarter of 2014, the euro area's economic growth froze (at 0.0%). In the EU at large, the economy grew by 0.2%. The latest Eurostat data not only underscored the uneven distribution of economic recovery but also the next division in the eurozone - of a good and bad recession. This division made formally Mario Draghi, the ECB chief, last week. According to him, the good recession is "technical", while the bad one stems from non-implementation of structural reforms. Germany has fallen into a "technical" recession with its economy shrinking by 0.2% in the period April-June.

Mr Draghi urged to make a clear distinction between the countries that do reforms and those who do nothing or very little reforms. He was cautious about Germany pointing out that an overall assessment needs to be made of the "technical factors". He hinted, however, that the main contributor for the German economic downturn could be the geopolitical factors. The ECB's expectations are in the coming two quarters the growth to be lower precisely because of the geopolitical problems. The bank is still unable to make a clear forecast of the impact of the economic sanctions against and by Russia, but underscored that the story of the countries that do not make reforms or very little reforms is completely different. They have had weak growth for months. Such is the case of France, which in the second quarter scored a zero growth, and Italy is already in recession. Its third since 2008.

The countries that do not make reforms or are not very bold in making them "have the highest taxation in the highest taxation part of the of the world", Mario Draghi said. This is the eurozone which, according to OECD data, has the highest taxation levels in the world. And non-reforming countries are the "top performers" in terms of tax burden. Mario Draghi was modest on 7 August when he presented the economic outlook of the euro area at his regular news conferences. The International Monetary Fund, however, is much bolder in its forecasts pointing out that growth perspectives are negative. In its analysis of the euro area, the Fund points out that in the short-term there will be negative shocks both domestically and externally, which could sour financial markets sentiment, halt the recovery and push the economy into low inflation or even deflation.

In the mid-term, there is a risk of stagnation stemming from deleveraging, insufficient growth boosting policies and because of stalled structural reforms. The appetite for structural reforms and deepening of the integration in the currency block, however, has dropped dramatically because of the outcome for euroscepticism at the European elections, is the Fund's assessment. This outcome could create a risk for the single market and, more specifically, the free flow of labour, and to put to the test the new fiscal governance framework. IMF also expects "reform fatigue" at national and euro area level which will significantly hamper the new Commission's efforts.

If there is a prolonged stagnation it will lead to significant spillovers to the neighbouring European countries through trade and financial channels. IMF calculates that each percentage point of economic slowdown in the euro area will result in a reduction of the growth in the emerging European countries by 1/2 and 3/4 percentage point. Those are all the Western Balkan countries which suffered the most by the debt crisis in the euro area and by the global financial and economic crisis of 2008. Low inflation already has affected the countries from the region and especially those whose currency is pegged to the euro, such as Bulgaria and Macedonia. In this regard, the Fund recommends a more aggressive policy by the European Central Bank. In addition, more work is needed in the following three areas: support of demand; improve the balance sheets of the banks and complete the banking union; and progress in structural reforms aimed at boosting investment, employment and productivity.

Despite the lack of a sufficiently clear forecast about the impact on growth of economic sanctions and the deterioration of the geopolitical situation, it is obvious that in the euro area a new division is looming which will create additional tensions at European level. Therefore, it will be crucial whether the new European Commission President Jean-Claude Juncker will accept such a division and how will his team approach it. Even more important, however, will be how will the new division be met in the European Council. It is not hard to predict that it will not be welcomed and will certainly strain even more the relations in the Council precisely because of the real risks of new spillovers of recession.

This could have serious consequences for the Baltic states which continue to score the most dynamic growth in the eurozone and beyond. Lithuania registered growth of 0.7% in the second quarter, Latvia 1.0% and Estonia 0.5%. Latvia is the newest member of the currency block - since 1 January this year - and Lithuania has already been given green light to introduce the single currency as of January 1st next year. The Baltic states expect to suffer the most by the sanctions against and by Russia because of their excessive dependence on Russian markets and imports of energy resources. A positive growth have scored also countries that went through bailout programmes, like Spain (+0.6%), Portugal (+0.6%). Even in Cyprus the economy has slowed down its decline. Their efforts, however, could be wiped out by the countries with "bad recession".

That is why, it will be, indeed, very important how will the Commission and the Council address the fact that in some countries the recession is "bad" and in others it is simply a consequence of the international context. Very telling about the intentions of the member states will be the decision who should be the commissioner on economic and financial affairs - will he/she come from a country with "bad" recession or with a "good" one. On how will the talks begin on the return of the crisis will depend also the fragile unanimity on imposing sanctions against Russia. So, the political season in the EU this year begins on August 30th when an extraordinary summit will take place to decide on who will be the successors of Catherine Ashton and Herman Van Rompuy.