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Growth papers over Europe's cracks

Gavin Hewitt | 10:51 UK time, Wednesday, 18 August 2010

As we entered summer the mood in Europe lifted.

The threats to the euro seemed to have passed. It was easier and less expensive for governments to raise money. The banks were put through their stress tests and most of them passed. Greece was praised for its budget-cutting rigour.

And then growth - which had proved so elusive - returned. The eurozone grew by 1% in the second quarter. That was more than many had hoped for.

But you don't need to probe very far beneath the surface to find nerve endings jangling. One set of figures, like a German index suggesting that investor confidence is actually slipping, can rattle markets.

Firstly, Europe's growth is hugely dependent on Germany. It is once again an economic powerhouse. Its exports are surging. Papers in Germany are calling it a new "economic miracle". The economy is now growing at its fastest in 20 years. If any country is hauling Europe out of recession it is Germany.

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"It is the same old story," says Carsten Brzeski of ING. "Germany is in a league of its own, carrying a few of its neighbours along, and beneath that, the laggards that are teetering on the brink of recession."

In the eurozone there are really three economies. There is Germany which in the second quarter saw growth of 2.2%. It is way out in front of the rest of the pack.

Then there are the middle-rankers like the Netherlands and France which saw growth of 0.6%.

Then there are a clutch of weak countries at the back of the field. Spain, with a growth rate of 0.2%, is barely out of recession. The Greek economy actually shrank by 1.5%. Ireland is struggling.

So the great divide is widening. A relatively weak euro, brought lower by the difficulties in countries like Greece and Spain, is benefiting Germany. Many economists believe the euro is too strong for the weaker eurozone countries.

Now Germany remains committed to austerity. Even though tax revenues are proving healthier than imagined, Berlin is committed to slashing its budget by 80bn euros (£66bn) over four years. A spokesman for Angela Merkel was quoted in the Financial Times as saying that "consolidating the budget is the main priority".

That is the message - get the deficits down, shrink the debt. Germany could ease off but it won't; it fears other countries would lose their appetite for spending cuts. As Angela Merkel said earlier in the summer, when defending her austerity package, Germany has to set an example.

The big argument over austerity is set to intensify. Budgets are being slashed but the question is whether they pave the road to economic health or whether they lock countries in a cycle of decline.

The EU and the IMF have heaped praise on Greece. It has made "remarkable progress" in cutting its spending. Down 40% this year. But its economy is shrinking. It contracted 1.5% in the past quarter and is expected to decline by 4% for the year. Unemployment is 12% and rising. Tax revenues are less than predicted. Investment is down. It is unclear where growth will come from.

Take Ireland. It was called the "poster boy" for attacking its deficit. It embraced austerity early and courageously. Not only were public sector wages cut, but benefits too. The pain was not spared. Carers are having their hours cut. Some hospital beds are being closed. But more bad debt was discovered in its banking system and its budget deficit has actually gone up to 18.6%.

Meanwhile, all around are signs of deflation. In parts of the private sector wages have fallen by over 10%. Prices fell by 1.2% in July after falling by 2% in June. Rents are down. Unemployment is 13.7%. Ireland has yet to pull out of its dive.

Spain was always a reluctant budget cutter. The government resisted until outside pressure forced its hand. Its economy is so weak that unemployment remains over 20%. Public sector wages have been cut by 5%. There are reductions in benefits.

So Europe is witnessing a booming Germany and savage deflation in the weaker countries in the eurozone.

Many of the austerity measures are yet to hit. It is early days. The stories about medicines not being available on the state, or of childcare being cut, or of teacher shortages, are still anecdotal. What is certain is that the public sector is set to shrink. It is a fair bet that sometime during the autumn some governments will wobble over their austerity programmes. There may even be calls for fresh stimuli.

Europe's bailout packages bought the eurozone time. There is serious work going on to address the problems. The Task Force on Economic Governance, chaired by Herman Van Rompuy, is acutely aware that the crisis has not passed. Growth may ease the stresses and strains, but the big question remains unanswered: how can countries with such different economies inhabit a monetary but not a fiscal union?

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