Europe’s Crisis Measures Are Working…Sort Of

Recession shows no sign of ending and unemployment is rising, but deficits and labor costs in some the crisis-hit countries are coming down

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Kostas Tsironis / Bloomberg via Getty Images

Yannis Stournaras, Greece's finance minister, arrives for a news conference in Athens on Nov. 28, 2012.

Last week’s deal to avoid Greece defaulting on its huge debt is the latest twist in Europe’s painful, drawn-out saga to rescue the euro and, with it, all hopes of bringing its economies into a true union. The focus remains on a mixture of short-term fixes to avoid a breakdown of the single currency, and complicated longer-term measures such as the establishment of a banking union.

But stepping back for a moment, it’s useful to look at the impact of all the measures that have been decided and implemented, both in national capitals and at a pan-European level, in an endless series of emergency meetings and carefully constructed communiqués. Have they actually made a difference?

The short answer is that the economic picture throughout Europe still looks very gloomy, and in fact is getting even gloomier, with recession continuing across the continent and unemployment continuing to rise. At the same time, the draconian measures undertaken by governments in Greece, Spain, Ireland, and elsewhere  – often in the face of mass protests – are starting to have an impact. Budget deficits are getting smaller, and several countries are slowly starting to claw back some of their lost competitiveness as they impose tough austerity policies.

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The big question is whether these changes are good, bad, or enough. Perhaps inevitably, economists are caught up in some fierce arguments over the issue.

On the one hand is the Organisation for Economic Cooperation, which this week presented its economic outlook for 2013 and 2014. Pier Carlo Padoan, its deputy secretary-general and chief economist, isn’t particularly optimistic about the eurozone, seeing a host of unresolved issues from undercapitalized banks to slow progress on a fully-fledged banking union. But he and his colleagues at the OECD say the sometimes brutal adjustments being made are vitally important if the eurozone’s health is to be restored – and they see some progress.

Unit labor costs are one indicator. Before the crisis, labor costs in places like Greece and Spain rose very rapidly – far more so than in Germany, where they hardly budged.  The result, in a single currency area where devaluation is not possible, has been to render their economies less and less competitive, and severely hurt exports, which became overpriced. In fact, spiraling labor costs were an important reason why some of these countries got into such a mess.

Now the trend is going the other way, and quite dramatically in Greece, Ireland, Portugal, and Spain, where unit labor costs have been dropping sharply. For those interested in the exact numbers, the OECD has a spreadsheet with the main ones here.

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Look at current account balances in the euro area – a net measurement of trade – and a similar picture emerges. The current account deficit in Greece, Portugal, and Spain has narrowed sharply in the past three years, and Ireland even has a surplus again. All this amounts to positive signs, Padoan says: “You have to face the music and become more competitive.”

Such views reflect the policy orthodoxy of eurozone governments – and they are strongly contested by some economists. Charles Wyplosz, a professor at the Graduate Institute in Geneva, argues that the worst-hit eurozone countries are in “a circle of impossibilities,” a sort of economic Catch-22: If they are to remain in the Eurozone, they need to get out of recession, which will mean they need to ditch their austerity policies; but since they are so heavily in debt, they can’t embark on an economic expansion and may not even be able to abandon austerity. Wyplosz’s conclusion: Only a massive write down of their public debt will solve the problem – and for the moment there’s little chance of forging a political consensus around that issue.

In other words, no amount of painful internal adjustment is going to break the vicious circle.

Other leading economists, notably Nobel laureate Paul Krugman, also argue that European policy is heading in the wrong direction and actually making a bad situation even worse by insisting on continued austerity.

What’s indisputable is that the economic outlook is worse in Europe than in the U.S., where the “austerians,” as Krugman calls them, have not had the upper hand in quite such obvious fashion. The eurozone economy overall is in recession and the OECD predicted this week that it will continue contracting in the first quarter of 2013, and for the year will show growth of -0.1%. Within that forecast there are some considerable variations: The German economy is expected to grow by 0.6% next year, while Spain is likely to see a 1.4% contraction and the pain in Greece will continue, with another fall of 4.5% forecast.

By comparison, the OECD expects the U.S. economy will grow by 2% in 2013.

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Unemployment, which is starting to decline in the U.S., is also continuing to rise in Europe. And both consumer and business confidence is falling in Europe, even as it’s slowly picking up in the U.S. The OECD worries that the biggest downside risk to the world economy remains the fragility of the eurozone.

Among the still unresolved problems: very weakly capitalized banks in countries including those that have so far been relatively spared by the crisis, such as Germany, France, the Netherlands, and Finland. While the major U.S. banks have taken tough action to shore up their balance sheets, banks in the euro area haven’t been as rigorous, and need an estimated $500 billion in additional capital if they are to raise their core Tier-1 capital to 5% of their total assets.

In other words, after two years of crisis, there are some positive signs in Europe, but the economy overall remains extremely fragile. And even when it comes to labor costs and trade, some countries continue to go in the wrong direction, notably France.

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