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As fear of an implosion receded, the economy recovered. The gross domestic product of the euro area is likely to have expanded by 0.5 per cent in the second half of 2013; Portugal came out of recession in the second quarter, Spain in the third quarter; Italy stopped contracting in the fourth quarter and Greece is expected to return to growth in 2014 for the first time in seven years; Ireland defied most forecasts by growing 1.5 per cent in the third quarter alone.
Spain, Portugal and Greece eliminated vast current-account deficits, reducing their reliance on foreign borrowing—and not just by slashing imports; Iberian exports in particular have surged, aided by structural reforms that have boosted competitiveness. Budget deficits have been cut: Greece's 19 per cent fiscal adjustment is a remarkable achievement that should allow the country to deliver a primary surplus before interest costs in 2013.
At the same time, government debt levels remain precariously high, leaving economies vulnerable to external shocks, including from China or as a result of the US Federal Reserve's decision to dial back its bond-buying. Some economists fear the eurozone is at risk of "turning Japanese" and argue that much looser monetary policy is needed in the form of the ECB engaging in some money-printing of its own to prevent a slide into outright deflation.
Nor can further political instability be ruled out. The economy may be recovering, but it won't feel like it for many citizens. It is likely to take years for Southern European economies to rebalance away from non-tradeable sectors such as construction and government services toward new export-orientated tradeable sectors. As a result, unemployment is likely to come down only slowly, exacerbating social tensions.
What would transform the economic outlook—and help ease deflation fears—would be an upturn in business investment and German domestic demand. On both counts, there are reasons for optimism. Corporate investment has been exceptionally weak for five years, suggesting clear potential for a powerful snap back as confidence returns. At the same time, there are signs that ultralow borrowing costs are finally tempting Germans to start spending: German domestic demand rose by a surprise 0.7 per cent in the third quarter and was the biggest contributor to growth.
Efforts by banks and regulators to strengthen capital ratios before the ECB takes over responsibility for bank supervision at the end of 2014 should also help build confidence.
Indeed, it is even possible 2014 will see a reversal of the vicious spiral of recent years with higher growth, falling unemployment and stabilising house prices leading to increased demand for—and supply of—credit. After all, this is exactly what seems to have happened in the UK and Ireland in the second half of 2013—and no one saw that coming either.