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Despite the fact that European economies and the US both suffered a great deal during the financial crisis, the Eurozone has been much weaker than the US in recovery. It has been lagging behind the US economy for years in many ways: in wages growth, unemployment levels and the time it took to return towards better health.

Why?

When the financial crisis was unfolding in 2008 and the scale of the damage had been revealed, policymakers realized that there was an urgent need for intervention to prevent economic collapse, the scale of which hadn’t been seen since the great depression in the 1930’s.

Central banks were supposed to slash interest rates to very low levels, and provide support to the banking system which was crumbling, while Governments were there to make sure that these banks had enough money to keep lending (liquidity) and they used taxpayer money to do it. Both the Eurozone and the US did these things, but one was much more slow to act than the other.

Extreme measures such as bond-buying (otherwise known as ‘quantitative easing’ or ‘QE’) and slashing interest rates were employed much more quickly by the USA’s central bank, the Federal Reserve, after the financial crisis. This prevented even more destabilizing taking place within the economy which was incredibly fragile after the 2008 crash.

Weaknesses in the eurozone’s design impaired it’s ability to recover in comparison to America. Many critics of the EU have said that the reason it continues to struggle and stagnate economically is because of the way it fundamentally works and because of problems with it’s currency.

The fact is that countries in the EU are bound together through money. 19 of them use the Euro (single currency), and are wrapped up in something called  ‘monetary union’. Monetary union is a way of converging (or bringing together) the economies of members of the EU. There are 3 stages to go through before a country can join the single currency, and each one brings about more integration each time. This ties into the concept of political union as well, not just monetary union, for it is not just a economic project but a political one too. However, when many of these countries have vastly different economies, political systems, cultures and standards of governance, things get tricky. Critics argue this model was doomed to fail from the start and is a big part of the reason for weaker recovery.

The Nobel Prize winning economist Joseph Stiglitz has spoken about this at length, and penned a book about the Euro. In The Guardian last year, he gave his verdict on European integration, saying: “The Eurozone was flawed at birth. The structure of the eurozone – the rules, regulations and institutions that govern it – is to blame for the poor performance of the region, including it’s multiple crises. The diversity of Europe has been its strength. But for a single currency to work over a region with enormous economic and political diversity is not easy. A single currency entails a fixed exchange rate among the countries, and a single interest rate. Even if these are set to reflect the circumstances in the majority of member countries, given the economic diversity, there needs to be an array of institutions that can help those nations for which the policies are not well suited. Europe failed to create these institutions.”

In comparison, the U.S is a massive country and a diverse nation, but not to the same extent as Europe in terms of it’s economy, institutions and rules, and this is partly why getting back to normal since economic problems kicked up a gear in 2008 has been so painful for many countries in the European Union, as opposed to the USA.

The former Governor of the Bank of England Mervyn King gave his view about this in his book ‘The End of Alchemy’. He wrote: “The tragedy of monetary union in Europe is not that it might collapse but that, given the degree of political commitment among the leaders of Europe, it might continue, bringing economic stagnation to the largest currency bloc in the world and holding back recovery of the wider world economy. It is at the heart of the disequilibrium in the world today.”

He mentioned disequilibrium because since the EU is a global player economically, when it suffers, growth across the world suffers too.

We see examples of this disharmony through the disparity in economies in the Eurozone, especially when we look at the differences since the public debt crisis started in 2009. The contrast between Southern Europe and Central and Northern Europe economically is staggering, and the South has suffered more. In Mediterranean countries unemployment is higher and so is public debt. To give an example of just how strong that contrast was, in 2015, Estonia’s public debt was 9.7% of GDP, while Greece’s was 176%. Similarly in Italy, public debt % of GDP was 132.7 and in Portugal it was 129%.

Countries in the EU have been dealing with worse economic conditions than America as a part of the slower recovery. The US unemployment rate in 2009 hit 10%, but since then it’s declined by more than 5%. In the Eurozone however, the picture has not been as rosy. It’s been stuck in double digits since 8 years ago. About one out of 5 young people eligible to work are unemployed. This is a colossal number and Southern European countries have been hit hardest.

Tensions between European financial authorities and governments in the Eurozone have also held back growth and created hostility between nations and this can be seen clearly in the case of Greece. According to economists, Greece’s massive debt could be written off more simply or the repayment terms could be eased, but because of the EU’s obsession with deficit reduction as part of it’s ‘Growth and Stability Pact’, it hasn’t happened. Instead the EU Commission has pulled Greece through a vicious cycle of fiscal adjustment, which resulted in less output, which again hurt it’s economy. Other EU countries continue to miss their deficit reduction targets, but the Commission has softened it’s stance on them and left them off repeatedly. This is partly because austerity in countries like Greece has been very unpopular, and has unleashed populist and far right parties – things that the EU does not want to deal with. It doesn’t want the same to keep happening elsewhere. Thorny issues like these have made things harder for the Eurozone as a whole.

The Southern European countries mentioned earlier are also countries which have suffered continuing problems with their banking systems, especially in Italy. Problems with banks are a big part of the recovery story. The world’s oldest bank ‘Monte dei Paschi di Siena’ in Italy made headlines throughout 2016 for all the wrong reasons. It was riddled with hundreds of billions of Euros in bad loans and needed a massive bailout as the year drew to a close, which underlined the fact that many financial institutions across Europe still face an uphill battle. Similar stories emerged from Portugal, on which the ratings agency Moody’s said in a report in 2016: “Prospect’s for Portugal’s banks have weakened again, as the mild economic recovery over the past two years has not been strong enough”. They also said, “Collectively, Portuguese banks are also among the most weakly capitalized in the euro area and we don’t see much room for improvement over the next 12 to 18 months.” The International Monetary Fund (IMF) also linked Portugal’s problems with it’s banks to Italy, identifying them as risks to global growth prospects.

America had it’s own banking problems after the crisis. Key institutions were on the brink of collapse which would have left the US (and the world) in an even worse state. However, the government and Federal Reserve stepped in quickly and undertook very unpopular and extreme measures (taxpayer bailouts) to try and get a hold on the situation. Due to that, US bank’s generally haven’t had to deal with the kinds of issues that European ones like Montei dei Paschi have, which is also a reason why the country got ‘back on the horse’ more quickly.

The problems for European banking are nothing new and are a persistent reason as to why recovery was worse there. Back in 2013, Philip Whyte, a Senior Research Fellow at the Center for European Reform, wrote: “The reason the eurozone has experienced a weaker recovery than the US is that it has made more glaring mistakes. Many Eurozone countries were slower than the US to repair their banks (perhaps because they gambled that recovery was imminent and that banks would soon be restored to profitability). Sickly banks have weighed heavily on the Eurozone.” Despite the fact that this was written over 3 years ago, banking problems are still affecting the Eurozone’s ability to recover to this day. He also wrote, “for a variety of reasons – political, institutional and other – the ECB has turned out to be a more cautious central bank than the US Federal Reserve, with sometimes unfortunate consequences.” Again, 3 years later when we look at the difference between the ECB’s decisions to keep interest rates on hold and the US Fed’s more hawkish (optimistic and bold) outlook (they plan to increase them multiple times into 2017), we can see his words still ring true.

How was last year for the Eurozone?

2016 showed a marked contrast between the economy of the Eurozone as a whole and the US.

While the latter posted solid jobs growth, falling unemployment and other health indicators routinely during the year, the Eurozone struggled on at a slower pace, despite a similarly dovish (cautious) view from the central banks of both, until December.

The divergence between the US and the Eurozone economies became much clearer then, after the Federal Reserve hiked interest rates and set a target for 3 further increases in 2017, off the back of more good jobs data which showed more and more people were in work with wages rising. In the Eurozone meanwhile, the central bank (the ECB) was pretty cautious in it’s outlook for 2017. We know this because it ended up keeping interest rates at the same level unlike the Federal Reserve and said it would be extending it’s bond-buying quantitative easing programme well into next year.

What next?

Things might be starting to turn around, but we say this with a cautious tone. It wasn’t all doom and gloom for the EU at the end of 2016 / beginning of the new year.

Investor sentiment in the Eurozone improved in January, reaching it’s highest level since August 2015. In early January, the December composite PMI survey for the Eurozone (which looks at services, manufacturing and construction) came in at 54.4. Anything above 50 represents an increase and growth in economic activity, so there are more reasons to be cheerful (just like the ECB President Mario Draghi, above).

The problem is that there is still more challenges left to face. While the US does have issues to contend with as a new untested President takes office, economically speaking it had a robust end to 2016 and things are looking up right now. There were big rallies in US stock markets as investors started heading back towards equities instead of bonds after Trump’s election. On top of this, non-farm payroll (jobs and wages) data was strong too, with a big boost to wages in the last report released in January 2017 which tracked results for December 2016. In contrast, the EU’s situation is looking less optimistic.

Populism has won in the US with Donald Trump, but many European countries are yet to make the choice whether to maintain the status quo or not. Will they stick with the EU model or look elsewhere?

When looking at why the US has recovered faster, it’s only fair to the EU to point out the US doesn’t face the prospect of the ‘united’ part of the United States falling apart in the same way that the European Union may lose it’s ‘Union’. This year there will be elections in Germany, France and Italy which may rock the EU. If those countries elect anti-EU leaders, they might end up leaving the bloc or scrapping the single currency all together, which would throw a huge spanner into the works of the project. This could throw prospects for Eurozone recovery into more jeopardy, due to further financial and political uncertainty. If this happens, 2017 may contain even more upsets than last year. This might mean that the Eurozone drops behind the US even further again in growth. This will have knock on effects on financial markets, as investors look elsewhere to put their cash.

Why does it matter?

The US and the EU are massive global players in terms of economies. In our interconnected world, when one huge body of countries suffers economically, we all tend to be worse off, but especially those living inside them.

In investing terms, we can’t ignore any of the factors that influence the markets and our prospects for making money. As investors we desire safety and certainty, but this is difficult when financial markets are inherently unstable. Understanding factors like the ones described in this article can then help us to decide where to invest, and help us to be clear on the context of why markets in Europe and elsewhere move the way they do.

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