This week's interest rate cut marks a milestone for the European Central Bank.
For the first time in two decades, policymakers can begin an easing cycle without forcing themselves into a financial crisis. Investors are showing confidence in the euro zone, keeping yields in check.
But despite the outward calm, the economy is starting to feel the effects of problems decades in the making: Increasingly overshadowed by U.S. dynamism and the rise of China, the euro zone is struggling with slow growth, declining productivity, worsening demographic trends and bloated finances in major countries.
Market stabilization and economic recovery give Brussels and national capitals valuable time to address these challenges. Unless politicians, facing European elections this week, seize the opportunity to quickly deliver pro-growth reforms and fiscal consolidation, the region risks sliding further into irrelevance.
“Absent a major shock, the European Union will likely decline significantly as a global power and the United States will likely compete with China for economic dominance,” said Jamie Rush, the European Commission's chief economist. Bloomberg Economics.
The sense that the euro zone is now at a turning point is palpable. The ECB's rate cut comes at a time when the euro's worst inflation in history has all but ended and a shallow recession has ended with an unexpected surge in growth.
The spread between Italian and German bond yields, a key indicator of risk, narrowed to a two-year low at the start of 2024. Yields have risen slightly as investors assess how much the ECB can cut rates given a stronger-than-expected economic recovery, but there is no sign of the fragmentation fears that threatened markets ahead of 2022’s first rate hike.
“'Europe is the worst' is a phrase you used to hear a lot from investors outside Europe. But you don't hear that anymore,” said Roger Hallam, global head of rates at Vanguard Asset Management.
Supporting this view is a more coherent policy backdrop at the regional level, including the previously unthinkable pandemic-era European Union (EU) recovery plan, “NextGenEU,” which even includes debt pooling, and new crisis measures announced by the ECB to stimulate the economy and rein in bond markets.
Evidence of the region's resilience emerged last year when investor panic led to the collapse of U.S. and Swiss banks. The euro zone, which marks the 10th anniversary of its unified supervision later this year, has suffered no such casualties.
But the region's long-term problems seem more ominous than ever.
“Europe is in an improved position now, but serious structural challenges lie ahead, including an ageing population, climate change and global divisions,” Alfred Comer, a senior official at the International Monetary Fund, warned in May.
Low productivity, and the resulting low potential growth rate, is one of those problems. The EU as a whole has been consistently less productive than the United States this century, a result of slower growth in living standards and “weakening global economic power,” the European Centre for International Political Economy said in a May study.
The economic gap between Europe and the United States since 2000 will reach around 18% of potential GDP in 2023, equivalent to more than 3 trillion euros, according to a new study. Bloomberg Economicspredicts that the shortfall will reach nearly 40 percent by 2050.
“We as Europe have to do more,” German Finance Minister Christian Lindner told reporters in Italy last month at a meeting of European nations that focused on the gap between the United States and Europe.
Another major issue is ageing populations, as pensions across the region are primarily publicly funded from current tax revenues, further raising concerns about low growth potential and debt sustainability.
“Birth rates are much worse than expected,” said Oliver Rakow, an economist at Oxford Economics. “This is not just a two-, three-, or five-year problem, but it's a big problem in the long term.”
The most immediate problem is the deterioration of public finances in countries already struggling with austerity measures: Italy stands to become Europe's most indebted in just three years, according to Scope Ratings.
IMF projections show that debt-to-gross domestic product ratios are also now gradually rising in France and Belgium, with deficits well above the 3% cap that the EU is trying to enforce.
While bond markets suggest investors are unfazed, past sovereign financial turmoil in the region offers a useful lesson in how quickly sentiment can change.
“The risks are rising,” said Moritz Kraemer, chief economist at LBBW and a former senior ratings analyst at S&P Global Ratings. “I don't think the market is worried enough.”
While the government may make every effort to contain the debt deficit through spending cuts and tax hikes, achieving better economic growth in the long run will offer the best prospects for fiscal consolidation.
This is one area where we are currently seeing a proliferation of ideas at EU level.
In mid-April, former Italian Prime Minister Enrico Letta released a report on the future of the European Union's single market, calling for, among other things, the integration of telecommunications providers and further integration of energy markets.
Former ECB President Mario Draghi is due to publish a long-awaited report on the future of European competitiveness soon, which will call for “radical reforms” to curb corruption, including reducing regulatory burdens and possibly even huge subsidies.
“Without strategically designed and coordinated policy measures, it is not surprising that some industries will shut down or relocate their production capacities outside the EU,” he said in April.
Meanwhile, French President Emmanuel Macron is pursuing his own policies, including pushing for greater integration of capital markets, following the success of the United States in creating a huge pool of capital.
“My concern is not just France, but Europe compared to the United States and China,” he said. Bloomberg “My first priority is to put forward the European policy that we need to be more innovative, we need to have more efficient capital markets, we need to invest more from our common European budget and the private sector.”
The EU is always full of ideas that it struggles to implement, but there is perhaps more momentum than usual for the bloc's efforts at self-improvement.
“We hope that the Letta report, the upcoming Draghi report and the EU elections will act as a kind of catalyst, providing an opportunity for policymakers to focus on key issues,” said Paul Hollingsworth, chief European economist at BNP Paribas.
But Europe has a poor track record with policy implementation, said Konstantin Veit, a portfolio manager at Pimco. “There are a lot of things right in these reports, but if history is any guide, very little will actually be implemented,” he said.
Large-scale reports and initiatives were once a more common way of promoting European integration, as evidenced by Europe's efforts in the 1980s to create the single market, one of its signature success stories.
But more recent innovations, such as Draghi's tools to calm markets in 2012 and the recovery fund measures during the pandemic, have been born out of turmoil.
“We would love to see a next generation or even a permanent EU 2.0 combined with capital market integration,” said Mikala Marxen, group chief economist at Societe Generale. “Hopefully we don't need to go through another crisis to move forward.”
(Additional reporting by Aline Oyamada)
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