In unsurprising economic news recently, the European Union announced that the eurozone's gross domestic product contracted in the second quarter. It wasn't a catastrophic report. Growth was off by 0.2% from the first quarter, and France and Germany managed to stay out of negative territory. But the fact that things could have been worse is cold comfort.
Growth is and will remain one of the biggest challenges to Europe truly fixing its debt crisis. Unfortunately, growth will be one of the trickiest problems to solve. The crisis is shrinking growth, but growth is needed to truly solve the debt crisis. To break this cycle, Europe will need to stop kicking the can down the road and act decisively to stem the crisis.
Contributing Factors
Although it is hard to pinpoint one reason why Europe is slipping into a recession, the debt crisis is clearly a major contributor. Business confidence is clearly one area that is dragging down growth as businesses generally hate uncertainty. Before making a big investment in either capital or in new employees, they want to make sure that they have a reasonable view into the future. Recently in the United States, this has meant worries about what will happen to top marginal tax rates, what changes could be coming to the regulatory regime, or if Congress is going to fix the fiscal cliff. European businesses have it even worse. Managers can't even be certain what currency they will be using in a year. Add in the worries that the crisis could keep getting worse, and you have a recipe for retrenchment in the corporate sector.
A scared banking system isn't helping matters either. Banks across Europe, particularly in peripheral countries such as Spain, are not in the strongest shape at the moment. Their books are loaded with potentially bad loans, and management teams are focused on trying to improve their capital ratios in order to meet new regulatory requirements and try to create a buffer to survive the storm. Lending money to businesses looking to invest and expand is not top-of-mind for these financial institutions. The European Central Bank's lending programs and talks of direct bank bailouts have eased the problem somewhat, but it is still a major quandary facing European business today.
Austerity measures are also having a profound impact on growth, particularly in the periphery. These measures have been agreed to in some cases to stave off the need to ask for bailout money and in other cases as a condition of bailout money. Either way, it means that spending on government projects and government employment is down sharply in some areas. These adjustments are needed to bring long-run budgetary solvency, but in the short term the reduction in spending is likely creating a headwind to growth.
Consumers aren't immune from the bad news emanating from the debt crisis, either. The combination of a very cautious corporate sector, banks that don't want to lend, and a pullback in government spending does not make consumers feel confident and want to spend. We've heard from countless management teams during the last few months that European consumers are generally behaving very cautiously, particularly on long-lasting goods such as cars. A Europewide pullback in consumer spending isn't exactly a harbinger of economic growth.
Not only is the sovereign debt crisis weighting down economic growth, a recession will make it that much harder to actually solve the debt crisis. Debt loads look much more unmanageable against the backdrop of a declining economy versus a rising one. In an improving economy, even if debt is held steady it will fall as a percentage of GDP. And the extra tax receipts that are coming in can help pay it down even faster. The growth creates a fighting shot of paying down debt to sustainable levels. When the economy is contracting, the exact opposite happens. A smaller economy will find it that much harder to burden a huge debt load.
Political Pains
Beyond the mathematical issues, a recession is going to exacerbate some thorny political issues that could very well be even more important in the short term. Almost any of the potential fixes to the problem will require big concessions from both the lender and debtor countries. Stronger nations such as Germany are going to have to commit to providing aid to the rest of the eurozone, perhaps indefinitely, while countries such as Spain and Greece will need make huge adjustments to their national budgets and implement far-reaching and likely unpleasant labor reforms.
These are politically difficult issues even in the best of climates. Against a declining economy, they become even more troublesome. If Germans start to worry about their economic security, they aren't likely to support policies to bailout their neighbors. Likewise, against the backdrop of soaring unemployment and insecurity, Spaniards, Greeks, and others aren't going to enthusiastically sign up for more cuts. The lack of growth threatens to shrink the already-incredibly small amount of space for needed political reforms to happen.
So can Europe break this vicious cycle of the debt crisis creating a recession and that recession making it harder to fix the crisis? Perhaps, but it will involve being decisive and making some important decisions now before the economy gets much worse and the window to solve the crisis completely closes shut. The exact solution could take many forms, but it will likely involve heavy involvement from the ECB, a strong fiscal union, and debt forgiveness for some countries. This is of course easier said than done. Throughout the crisis, Europe has not been very willing to make any big moves. Everything has been in fits and spurts, just trying to buy some time. These recent economic data underscore that the can just can't be kicked down the road forever without any consequences. Unless European leaders are able to come together and implement a bold plan, economic stagnation and potential dissolution of the common currency are on deck.
Jeremy Glaser is the Markets Editor for Morningstar.com.
