How Europe is using economics to combat political, security woes

Europe has seen a series of elections and political decisions that have a direct impact on European stability and economic development

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The last two weeks in Europe have been marked by a series of elections and political decisions that have a direct impact on European stability and economic development in both the short and long run. Some provide reassuring perspectives such as the victory of Francois Fillon in the French Republican primaries, Angela Merkel’s decision to run for a fourth term or the clear defeat of the extreme right in Austria which avoided the need for yet another debate on the EU’s values and viability as a common political project. Finally, the decision taken by Francois Hollande to withdraw from a reelection bid in France and the forecasted nomination of his Prime Minister Manuel Valls as the socialist nominee offers comforting perspectives on the monetary, fiscal and regulatory policies that will likely be implemented over the next five years in France.

On the other hand, the stinging defeat of Matteo Renzi last week in his quest to seek political legitimacy in Italy through a dangerous constitutional referendum have increased worries over the economic stability of the peninsula and contagion risks to the rest of the EU. Some feared a revival of a sovereign debt crisis comparable to that of spring 2012 when speculators questioned Greece’s belonging to the single currency. Perspectives are different however. Italy’s long-standing membership of the European Union and the maturity of its economy do not pose the same systemic risk to the euro area.

The situation remains uncertain nevertheless. Last week, the euro fell to 1.05 dollar, its lowest level in twenty months and Italian banks floundered at the Milan Stock Exchange. Several establishments, such as Monte dei Paschi di Siena, are hampered by more than €350 billion in doubtful loans and are seeking to raise fresh capital to strengthen their position. The situation is worsened by the high level of Italian government debt, exceeding 130 percent of the gross domestic product. Even though interest rates remain low – thus easing the debt burden – this dire financial situation limits the government’s already constrained room for maneuver.

In light of those systemic risks, the European Commission has finally opted for a strategic change to sustain economic activity on the continent. For the first time, it explicitly proposed to end the austerity policy it has been recommending to implement since the 2008 crisis and, on the contrary, advised to proceed with budgetary expansion in the euro area, at least for countries that can afford it. The suggestion to increase budgetary spending in the euro area by 50 billion dollars was applauded by southern European countries but viscerally contested by Holland and Germany who do not want to cover the bill.

Even in the absence of consensus, the Commission chose to send a strong signal. After the trauma of the Brexit referendum and the election of Donald Trump in the United States, the European Union realized that without a change in its economic strategy, it would risk feeding a little more the populist wave or simply the Euroscepticism that now assimilates Brussels to austerity, globalization and lobbies.

Similarly, markets thought that the European Central Bank would initiate a tapering of its monetary incentive strategy to the European economy in light of the recent positive results. The euro area unemployment rate was indeed 9.8 percent in October 2016, down from 10.6 percent in October 2015, its lowest rate recorded since July 2009. Nevertheless, the Frankfurt Institute left its interest rates unchanged and extended its program of purchase of public and private debts – quantitative easing – beyond its forecasted end in March until December 2017. This nine-month extension will bring all debt purchases to at least €2,280 billion at the end of 2017 (the equivalent of 21 percent of the euro area’s gross domestic product).

If this decision answers an economic need – with an inflation rate that remains very low at 0.2 percent/year and a very modest annual GDP growth forecast of 1.6 percent – the objective is also very political. Ahead of a crucial year for European politics with general elections in Germany, Holland and France, pro-European government in power can use the financial leeway offered to appease their population and stand to populist and xenophobic movements. The ECB decision is also a clear signal of encouragement for countries to make the most of the low interest rates globally to invest in their economy and prepare the conditions for future growth.

This expansionary stance taken by the European Commission was also confirmed by the debt relief measures offered to Athens. In light of the colossal structural efforts made by the Tsipras government which reformed the national pension system, European leaders partially released their pressure to repay lenders.

Finally, Brussels also announced a series of common investments in the field of security and defense, suggesting the creation of a “defense fund” of €5 billion per year to be used both for research efforts (electronics, robotics, encryption, etc.) and as a financial instrument to facilitate joint purchases of equipment and thereby reduce costs. Although officially this decision has nothing to do with the likely geopolitical realignments following the election of Donald Trump and increased assertiveness from Moscow, it seems clear that the European institutions are moving away from a dogmatic respect of economic rigor towards a much needed adaptation to political imperatives and security concerns.

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