The Eurozone will survive after Brexit – even if the UK crashes out of the EU

Opinion piece (The Independent)
29 September 2017

It is hard to see a ‘no deal’ scenario derailing the Eurozone recovery – the currency union is simply not dependent enough on the UK for that to happen.

The combined economy of the 19 countries that share the euro is finally growing by a healthy amount after nearly a decade in the doldrums. It should expand by around 2 per cent this year, following growth of about that in 2016, and similar rates are expected in each of the next two years.

While this is no boom, it certainly constitutes a reasonable cyclical recovery, and certainly means that the Eurozone is set to outpace Britain’s struggling post-Brexit referendum economy. There are sizeable differences in growth rates between Eurozone members, but all, with the exception of Greece, are sharing in the recovery. Growth is also increasingly broad-based, with domestic consumption and investment providing most of the impetus. 

Is the Eurozone out of the woods? Can it prosper without further significant reforms? Much will depend on the longevity of the current growth spurt and the depth and timing of the next downturn. While there are risks to the Eurozone’s recovery, most economists expect it to run for some time yet.

The impetus to the recovery was a combination of ultra-low interest rates and other emergency monetary stimulus measures, the corresponding weakness of the euro, a phasing out of austerity measures as the worst of the sovereign debt crisis abated, and very low oil global prices.

The European Central Bank (ECB) responded to deflationary pressures by holding interest rates at record low levels. It also launched an emergency programme of quantitative easing – the buying of assets with newly created central bank cash to increase the money supply —that was so large that the ECB now has more assets on its balance sheet than the US Federal Reserve.

The German government, with its heightened fear of the inflation, was at times hostile to the ECB’s strategy. Hyperinflation in Germany helped create the dire economic conditions that paved the way for the rise of the Nazis. But the ECB has stuck to its guns, and deserves the lion’s share of the credit for the improved economic climate in the Eurozone. The easing of austerity was a one-off and is no longer contributing to growth. The euro and oil prices have also bounced back, but the Eurozone recovery has gained momentum.

The recovery may still be modest — the economy is only 4 per cent bigger than it was in the first quarter of 2008 — but it’s not just down to one-off factors; it has legs.

Average wage growth in the Eurozone remains low, but rising employment is boosting consumer confidence and with it spending. Economic data suggest there is plenty of pent-up demand after such a long period of weak consumption and both households and firms have rediscovered some appetite for borrowing.  

The longer the upswing lasts, the greater the likelihood of the Eurozone surviving the next downturn without a further serious crisis. Fiscal positions and banks’ balance sheets will be stronger and the ECB will have been able to raise rates from the current lows, and therefore have some scope to lower them to counter the downturn. Conversely, if the recovery is relatively short-lived Eurozone governments and the ECB will have had less time to gather the firepower to counteract a slump.

There are several potential threats to the Eurozone recovery, but no certainty that any will actually materialize. The biggest external threat is probably a potential loss of confidence in the dollar should US growth disappoint or investors take fright at the Trump administration. A stronger euro would dent Eurozone exports.

The UK crashing out of the EU with no deal would pose grave financial, economic and legal problems for the UK, the Eurozone’s biggest single export market. This would no doubt hit the pace of growth in the Eurozone, especially if the two sides failed to rapidly resolve the resulting regulatory and legal issues to allow trade to flow in the manner it has before Brexit. However, it is hard to see a “no deal” scenario derailing the Eurozone recovery – the currency union is simply not dependent enough on the UK for that to happen.

Other possible external dangers include a surge in global protectionism, a Chinese financial meltdown, a security crisis in central and Eastern Europe, or upheaval in the Middle East leading to higher oil prices. But the likelihood of any of these coming to pass appears to be low.

The biggest threat from within the Eurozone would be a premature tightening of monetary policy. The ECB, and its President Mario Draghi, have stressed the recovery is young and inflation pressures remain weak. But the ECB could face growing pressure – particularly from Germany — to raise rates as the recovery continues. Berlin is also expected to push for Jens Weidmann, the head of Germany’s central bank, to replace Draghi in October 2019. A Weidmann presidency could raise fears that the central bank could increase interest rates sooner rather than later.

The Eurozone should try to use the recovery to build up its resilience to future economic downturns. French President Emmanuel Macron has proposed widespread reforms including on taxes and defence policy, but it remains to be seen how keen German Chancellor Angela Merkel is.

Nevertheless, while that debate continues the single currency area could focus on strengthening its banking system. It could also consider boosting the firepower of the Eurozone’s European Stability Mechanism, which provides financial assistance under strict conditions to Eurozone countries facing financial problems, though that process could take a long time.

The Eurozone economy is not booming but there are good reasons to believe the current cyclical recovery could go on for a few years, in sharp contrast to Britain’s worsening outlook. And the longer the upturn lasts, the greater the possibility of the Eurozone avoiding serious crisis come the next downturn.

Simon Tilford is deputy director of the Centre for European Reform. This piece first appeared here.