The Eurozone’s Hidden Strength

BRUSSELS –For years, the eurozone has been perceived as a disaster area, with discussions of the monetary union’s future often centered on a possible breakup. When the British voted to leave the European Union last year, they were driven partly by the perception of the eurozone as a dysfunctional – and perhaps unsalvageable – project. Yet, lately, the eurozone has become the darling of financial markets – and for good reason.

The discovery of the eurozone’s latent strength was long overdue. Indeed, the eurozone has been recovering from the crisis of 2011-2012 for several years.On a per capita basis, itseconomic growth now outpaces that of the United States. The unemployment rate is also declining – more slowly than in the US, to be sure, but that partly reflects a divergence in labor-force participation trends.

Whereas labor-force participation in the eurozone is on the rise, it has been declining in the US since around 2000.The departure of Americans from the job market reflects what economists call the “discouraged worker” phenomenon. And, indeed, the trend has accelerated since the recession of 2009.

In principle,declining labor-force participation should be a problem in the eurozone, too,given the prolonged period of very highunemployment that many European workers have faced. But,in the last five years,2.5 million peoplein the eurozonehave actually joined the labor force, as five million jobs were created, reducingthe overall decline in unemploymentby half.

Moreover, theeurozonerecovery has been sustained, somewhat unexpectedly, even in the absence of continuous fiscal stimulus. The heated discussions about austerity of recent yearshave beenmisplaced, with both critics and official cheerleaders overestimating the amount of austerity applied.The average cyclically adjusted fiscal deficit has been roughly constant since 2014, at around 1% of GDP.

Of course, large differences in the fiscal position of individual member states remain.But this is to be expectedin such a diverse monetary union.The truth is that even France, often considered a weakperformer, has deficit and debt levels comparable to those of the US.

A comparison with the US, as well as with Japan, also undercuts the common perception that the eurozone’s fiscal rules, including the (in)famous Stability and Growth Pact and the 2012“fiscal compact,” have been irrelevant. True, no country has been officiallyreprimanded for excessive deficits or debts. But the clamor over rule breaches at the margin hasovershadowed thebroad underlying trend toward sound public finances that the fiscal rules have fostered.All of this suggests thatthe “softausterity” pursued in many eurozone countries may have been the right choice after all.

To be sure,one should not overestimate the eurozone’slong-term economic strength. While the average growth rate might remain above 2% for the next few years, as the remaining unemployedare absorbedand the long-term trend of older workersrejoining the labor market continues, the pool of unused labor will eventually be exhausted.

Once the eurozone has reached the so-called “Lewis turning point” – when surplus labor is depleted and wages start to rise – growth rates will fallto alevel that better reflects demographic dynamics. And those dynamics aren’t particular desirable: the eurozone’s working-age population is set to decline by about half a percentage point per year over the next decade at least.

Yet, even then,theeurozone’sper capita growth rate is unlikely to be much lower than that of the US,becausethe difference in their productivity growth rates is now minor. In this sense, theeurozone’s futuremaylook more like Japan’s present, characterized by headline annual growth of a little over 1% and stubbornly low inflation, but per capitaincome growth similar to that of the US or Europe.

Fortunately for the eurozone, it will enter this period ofhigh employment and slow growth on sound footing – thanks, in part, to that controversial austerity.By contrast, both the US and Japan are facingfull employment with fiscal deficits higher than 3% of GDP – about 2-3percentage points higher than those of the eurozone. The US and Japan also have heavier debt burdens:thedebt-to-GDP ratio stands at 107% inthe US and more than 200% inJapan, compared to 90% inthe eurozone.

There is evidence that in the wake of a financial crisis, when monetary policy becomes ineffective –for example, because nominal interest rates are at thezero bound – deficit spending can have an unusually strong stabilizingimpact. But there remains a keyunresolvedissue:once financial markets have normalized, will maintaining a deficit for a long time provide continuous stimulus?

The fact that the eurozone’s recovery is now catching up with that of the US, despite its lack of any continuing stimulus, suggests that the answer is no. Indeed, the experience of the eurozone suggests that while concerted fiscal stimulus can make a difference during an acute recession, withdrawing that stimulus when it is no longer vital is preferable to maintainingit indefinitely. With austerity – that is, reducing the deficit, once the recession has ended –recovery might take longer to become consolidated; but once it is, economic performance is even more stable, because the government’s accounts are in a sustainable position.

JohnMaynard Keynes famously said, “In the long run, we are all dead.” That may be true, on a long enough timeline. But it is no excuse to dismiss longer-term considerations. In fact, for the eurozone, the long run seems to have arrived – andthe economy is still alive and kicking. Daniel Gros is Director of the Center for European Policy Studies.

By Daniel Gros