The Rise of Unemployment in the Eurozone: The Worst of the Crisis is Not Over

Paolo Guerrieri Professor of Economics, University of Rome Sapienza; Professor, College of Europe, Bruges

The Unemployment Crisis in Europe assets–U.S. Treasury bonds and some types of cor- porate debt–paid for by an expansion of the mone- The relentless rise in unemployment, particularly tary base. This kept interest rates low and helped in- youth unemployment in the majority of the euro- debted businesses and households. It has also been zone member countries over the last three years the major support for booming financial markets. is one of the most dramatic consequences of the protracted crisis in the euro area. At this stage, a After the announcement by Chairman Bernan- quarter of young Europeans have no job and face ke, there has been a big sell-off of risky assets in daunting prospects, to say the least, with reference emerging markets and, to a lesser extent, in devel- to the possibility of finding employment. Finding oped markets. It is too early to say whether this is measures to mitigate this problem and prevent the a temporary development or just a moderate de- deepening of the unemployment crisis has become risking. There are substantial risks with the Fed’s a major undertaking in Europe. exit plan. Stimulatory effects could be reversed be- fore private demand is strong enough and the U.S. An effective and wide plan of action with concrete recovery might slowdown, taking the entire global answers to this challenge is needed. The real con- economy down with it. Bond yields could rise too tribution that Europe can make to the fight against rapidly or too unevenly, and become a danger to unemployment, including youth unemployment, the financial system. Both effects could have nega- today is actually linked to the revival of the growth tive repercussions for the euro area and in particu- process. In the context of a prolonged overall stagna- lar for the peripheral high debt countries. This is tion in the euro, no incentive to the labor market will yet another reason not to further delay policy re- be sufficient in the absence of a sustained economic form to boost growth and reduce unemployment recovery. This applies today, as we argue below, to the in the euro area. profound changes in the austerity policies adopted so far. These policies are at the root of the ongoing The Recessionary Phase of the Euro Area crisis and will penalize the European economies for an extended period of time. The recent recognition The euro area registered its second recessionary in Brussels that a further softening of budget-cutting phase in the last four years and a very modest recov- targets is required given the economic reality of re- ery of 0.7 percent is expected for 2014 although the cord unemployment and a second year of recession unemployment trend will continue. The other very in the euro area is not enough. Rather than being disappointing outcome shown by the data is that the abandoned, austerity has simply been prolonged. gap between the reasonably prospering North and the struggling South is persistent but has slightly Another reason why Europe should act is that Fed consolidated. Unemployment rates are around 5 Chairman Bernanke recently announced that the percent in Austria, Germany and the Netherlands several rounds of QE, the greatest experiment in in 2014, but above 25 percent in Greece and Spain the history of central banking, might be nearing its and in the 11 to 16 percent range in Ireland, Portu- end. Since 2009, the Fed has been buying financial gal, Italy and France.

Think Tank 20: The G-20 and Central Banks in the New World of Unconventional Monetary Policy 51 Despite these alarming trends, the dominant and As a consequence, growth has suffered, recession rather optimistic European view is that the current and stagnation trends have hit all peripheral coun- combination of fiscal austerity and national struc- tries and the euro area at large. tural reforms are working well. According to this view, these policies need more time and a more The Deflation Will Not Work and Will flexible application at the country level to produce Increase the Risk of Populist Revolts the expected results. France and Spain were among those provided with this flexibility to meet their The flexible approach to austerity adopted in Brus- fiscal deficit-reduction programs. sels, even assuming deflation is mitigated, will neither solve the difficulties of the eurozone nor My fear, however, is that this apparent shift in pol- offer a viable exit strategy from the prolonged debt icy amounts to little more than a tactical retreat crisis for two reasons. First, austerity has a self- to respond to the backlash against austerity. Aus- defeating impact on growth when interest rates are terity is prolonged through these means, and this close to zero. The IMF references this numerous strategy will not be sufficient to modify the present times in its recent papers and analyses. Second, negative trends in Europe. the unresolved banking crisis and associated credit crunch in the euro area will further depress nomi- The optimistic reading suggests that the economic nal growth. As a consequence, this will increase performance of high debt countries has in fact the stock of debt in many highly-indebted coun- started to improve, and an effective adjustment tries. By deciding that the crisis was largely fiscal, process is underway. It is true that some recent im- policymakers ignored the underlying cause of the provements and real adjustments are taking place. difficulties—irresponsible cross-border lending A more careful look at the ongoing rebalancing in for which bank suppliers of credit are surely as re- the euro area and European Union (EU) indicates sponsible as citizens. that, in quantitative terms, the external adjustment of current account deficits is not sustainable and Given this perspective, it is very likely that the eu- fiscal problems remain devastating. Additionally, rozone will face a prolonged slump of the kind that rebalancing to-date is predominantly the result of Japan has experienced over many years and will the adjustment in the deficit. The main issue is that not return to significant economic growth for at the improvement of the deficits and economies of least the next decade. In particular, the economic these member countries largely reflects internal and social situation in Southern Europe is bound devaluations and collapsing domestic demand, to remain grim for several years. As things stand, which have plummeted in all highly-indebted all Southern European countries are facing the countries (more so in Greece and Ireland, less in prospect of a true lost decade. According to the Italy, Spain and Portugal). It is not at all clear that IMF, their GDP per capita will be lower in 2017 these countries could maintain their external bal- than it was in 2007. ance if growth and imports start to recover. In this kind of scenario, one could see two main Developments in the eurozone member states risks. The first risk is beyond this year and involves with large current account surpluses have so far restructuring public and possibly private stocks contributed only very marginally, if at all, to the of debts, which will likely become unavoidable in rebalancing of the euro area. And this asymmetry many eurozone countries. The second is that soci- has produced a deflationary bias in the eurozone eties may lose patience as long as stagnation per- as a whole. If most eurozone country governments sists. As a result, the risk of populist revolts against cut spending at the same time, the deflationary ef- EU-driven policies will increase and some coun- fect on internal demand on GDP would be further tries may become difficult to govern. magnified.

Think Tank 20: The G-20 and Central Banks in the New World of Unconventional Monetary Policy 52 Already, anti-European movements have gathered Still, monetary action is not enough. To revive an increased following as voters associate struc- eurozone demand, Europe’s internal imbalances tural reforms with rising unemployment and so- and Germany’s huge external surplus must be ad- cial stress. These forces have even had electoral dressed. Large trade surpluses will remain a power- success, as is the case with Beppe Grillo’s Five-Star ful drag on economic activity in the eurozone and Movement (M5S) in Italy. There is no doubt that put a big obstacle in the way of the needed adjust- European leaders need to address these dangers ments between member states. European countries and try to avoid an extended period of populism- with current imbalances will have to demonstrate inspired movements. how they intend to close them; the onus lies equally with those running trade surpluses as those with An Effective Growth Strategy Requires deficits. In effect, the pace of fiscal adjustment and Actions on Multiple Fronts policy in the North has major implications for the Southern European countries. Collectively, the Is there any alternative to status quo policies in Eu- economies of the eurozone comprise the second rope? As we know the answer is yes—at least on largest economy in the world. The trouble is that paper. One should first acknowledge that the cur- the eurozone is managed as no more than the sum rent strategy for combating the eurozone crisis is of its parts. The dramatic error of the austerity poli- failing and needs deep reformulations and recali- cy was, and is, to repeat this fallacy of composition. brations. The issue is not whether fiscal consolida- tion and external rebalancing are necessary—they In other words, convergence and adjustment will not are. Instead, it is how to make them economically happen automatically in the eurozone, but need to and socially sustainable. An alternative approach be policy-driven. New policy and governance pri- must combine more symmetrical macroeconomic orities are thus required in the eurozone in order to fiscal adjustment and investments with micro- put more emphasis on cooperative games in conver- economic policy measures aimed at encouraging gence and competitiveness. Three years ago, the Eu- structural reforms and productivity increases (to ropean Commission argued that rebalancing within narrow competitive gaps across member states). the eurozone needed to be symmetric if it was to be The categorical imperative for Europe is to return consistent with economic growth. It followed that to growth. Only growth can allow peripheral coun- economies with big trade surpluses are obligated to tries in Europe to pursue a strategy of fiscal con- rebalance their trade as much as the deficit coun- solidation and gradual reduction in unemployment tries. In reality, very little emphasis has been placed that is sustainable and effective at the same time. on rebalancing the surplus economies so far.

An effective growth strategy requires actions on A Banking Union is Essential for the multiple fronts. First, policies that support de- Eurozone mand are needed in the near-term. In this regard, the recent commitment by the ECB to keep the Second, a banking union should be established and monetary policy stance accommodative for as long completed since it was always considered essential as necessary, is effective. Expansionary monetary for the eurozone. The “vicious circle” between col- policy can provide very useful space through ad- lapsing banks and national governments forced to ditional conventional and unconventional mea- bail them out lay at the heart of the eurozone cri- sures. These measures include forms of credit eas- sis. Many countries are forced to seek EU rescue ing, looser collateral requirements for securitized aid when they cannot afford on their own to bail bundles of loans to small and medium-sized en- out banks that misbehaved in the easy credit years terprises, a negative deposit rate, and credit easing before the crisis. In the present fragile situation of for lending schemes. many banks and in a world that could soon be de-

Think Tank 20: The G-20 and Central Banks in the New World of Unconventional Monetary Policy 53 prived of the Fed’s QE support, a credible assessment 20-25 years with convincing measures such as ear- of the quality of banks’ assets is needed. Restoring marked national tax revenues. Very recently the the health of banks’ balance sheets requires quanti- president of the European Commission formally fying capital needs and creating a clear plan on how launched the high-level expert group whose func- to meet these needs. Furthermore, a banking union tion is to recommend reforms of the banking sec- process should be completed, with common deposit tor. It is set to provide a feasibility analysis on a insurance and common resolution procedures. So eurozone debt-mutualization scheme in the form far, only the single supervisory mechanism (SSM) of a redemption fund and eurobills. pillar of the banking union has been realized and will enter into force next year. The European Com- The Fall of Popular Support for Europe mission has very recently published a proposal for a single resolution mechanism (SRM). In its pro- These proposals and necessary steps are obviously posal, the European Commission has a lot of power complex and difficult. But they are absolutely nec- to make the final decision on which banks to resolve essary to change the economic policy of the euro- and how resolution funds are used. This is relatively zone, moving in the direction of boosting growth reasonable, but Germany is unlikely to accept the and creating jobs, especially for the younger popu- commission’s proposal. The risk is a delay in reach- lation. While some of these steps will be achiev- ing a final agreement on the bank resolution and re- able within the current framework for European covery directive. Still, the amount of hidden losses economic governance, other equally fundamental in bank balance sheets is ultimately quite large. In steps call for a significant deepening of the integra- the meantime, the danger is that the bank-sovereign tion process together with a further centralization link will be reinforced causing an increase in sys- of policymaking at the European level. temic and contagion risks across the eurozone. This process will not be easy. The majority of Euro- Third, there will also have to be some form of fis- pean citizens are deeply disappointed and discour- cal union and eurobonds, or an equivalent instru- aged by the continuing crisis and the failed auster- ment. On the one hand, the eurozone periphery ity policies intended to counter the effects. They suffers from too little competitiveness to achieve now seem very unwilling, if not downright hostile, external balance without significant domestic de- to the transfer of policy sovereignty to Brussels. flation and unemployment. On the other hand, the Certainly there is still a strong consensus in all periphery has too large a stock of debt problem— member countries—according to recent opinion both public and private. We know that the most polls—in favor of the euro choice. Yet popular sup- direct way to address an excessive debt problem port for the further strengthening of EU institu- is to write down the debt, a very extreme solution tions is at very low level. indeed. As already mentioned, in the absence of a significant change in the obtuse austerity policy, Ultimately this key issue should be addressed this extreme solution could become inevitable. to ensure a smooth functioning of the monetary Before that point, however, one should look to union and a revival of growth and employment in take alternative routes, and growth can also help the eurozone. It is a narrow but mandatory path. address the problem. The “European Redemp- The alternative is that Europe will keep muddling tion Pact” in which EU countries without bail- through; member states will continue with their out programs would transfer the portion of their current policies which will lead to depression and government debt that exceeds 60 percent of GDP EU authorities will become increasingly unpopu- into a common fund remains a valid proposal. Un- lar. This scenario risks transforming the European der the various versions of this proposed scheme, dream into a nightmare for all euro member coun- countries participating in the fund would have to tries, Germany included. make a binding pledge to redeem their debt over

Think Tank 20: The G-20 and Central Banks in the New World of Unconventional Monetary Policy 54