El-ErianWarns "Don’t Be Fooled" ByEurope’sTranquility
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AuthoredbyMohamed El-Erian, originallypostedatProjectSyndicate,

AugustistraditionallyEurope’sholidaymonth, with many government officials taking several weeks off. In the process, important initiatives are put on hold until the “great return” at the beginning of September.

This year, there is another reason why Europe has pressed the pause button for August. With a loomingelectioninGermany, fewwishtoundermineChancellorAngelaMerkel’slikelyvictory. After all, Germany is central to Europe’s well-being, and Merkel’s steady hand has allowed the continent to overcome a series of challenges over the last few years. As a result, many are eager to postpone any controversial policy decisions rather than rock the German political boat.

Someoftherecenteconomicnews has seemedtojustifythisapproach. At the end of July, the widely watched indicator of European manufacturing activity crossed the threshold signaling expansion for only the second time in 23 months.

Adding to the sense of comforting normality, several European officials have taken to the airwaves with optimistic pronouncements. Whereas the euro and the eurozone were “under threat just nine months ago,” European Council President Herman Van Rompuy recently declared, “this isn’t the case anymore.”

All of this has underpinned a much-welcomecalminfinancialmarkets. Sovereign interest-rate spreads have been well-behaved, the euro has strengthened, and equity markets have risen robustly.

Yet no oneshould be fooled. This summer’s sense of normality is neither natural nor necessarily tenable in the long term. It is the result of temporary and – if Europe is not attentive – potentially reversible factors. If officials do not return quickly to addressing economic challenges in a more comprehensive manner, the current calm may give way to renewed turmoil.

ThetaskforEuropeisnotjust a matterofrestartingandcompletingtheeconomicandpoliticalinitiatives, whether regional or domestic, that have been put on hold until after the German election. In fact, these top-down decisions, while admittedly complex and certainly consequential, may be the least of Europe’s challenges.

Europemustalsocounterandreverse micro-levelchallenges that are becoming more deeply embedded in its economic and financial structure. Each day that passes complicates the design and implementation of lasting solutions to four problems in particular.

First, joblessnesscontinuestospread. The overall unemployment rate (12%) has yet to peak, led by an alarming lack of jobs among the young (24% joblessness in the eurozone as a whole, with highs of 59% and 56% in Greece and Spain, respectively).

Second, adjustment fatigue iswidespreadandbecoming more acute. Long-struggling European citizens – especially the long-term unemployed – have yet to gain any sustained benefit from the austerity measures to which they have been subjected. And the result is not just general disappointment and worrisome social unrest. In the last few weeks, political stability in Greece and Portugal has been threatened as governments struggle with declining credibility and a rising popular backlash.

Third, bailout fatigue isapparent. Citizens in the stronger European economies are increasingly unwilling to provide financial support to their struggling neighbors; and their elected representatives will find it hard to ignore growing resentment of repeated diversion of national tax revenues, which has yielded only disappointing outcomes. Meanwhile, high levels of past exposure and weakening creditor coordination are undermining the availability of external funding, including from the International Monetary Fund.

Finally, littleoxygenisflowingtotheprivate sector. While Europe has succeeded in stabilizing its sovereign-bond markets, financial intermediation for small and medium-size enterprises remains highly disrupted. With most credit pipelines already partly blocked, the shortage of corporate credit will become more severe as regulators finally force banks to embark on a proper mobilization of prudential capital and shrink balance sheets to less risky levels.

Allofthisaddsupto a sadrealityforEurope. Despite hopeful blips in an economic indicator here and there, too many countries lack both immediate growth and longer-term growth engines. As a result, debt overhangs will remain problematic. Owners of private capital that could be allocated to productive investment will remain hesitant. And societies will continue to lack the jobs and capital investment that are essential for durable prosperity and general well-being.

Europe’sexternalenvironmentisnothelping, either. On the demand side, the ongoing economic slowdown in China is starting to affect companies’ orders and revenues, adding to the challenges stemming from the persistently sluggish US economy. Meanwhile, the euro’s recent appreciation (particularly against the Japanese yen) limits Europe’s ability to compensate for anemic global demand by capturing greater market share.

These developments point to a much larger phenomenon: becauseofdelayedawarenessofthecomplexchallenges (andtherelatedslowandpartialpolicy responses) facingmuchoftheWest, thelow-equilibriumgrowthpatternthat has prevailedinrecentyears (what has beencalledthe “new normal”) isbecominglessstable. And Europe is a leading indicator of this.

In essence, Europe (andtheWest more generally) owesitsrecenttranquilityto a series of experimental measures by central banks to offset the troubling combination of too little demand to generate sufficient job creation, inadequate structural reforms to revamp growth engines, debt overhangs that undermine productive investment, and insufficient policy coordination. Consequently, the resulting surface calm masks still-worrisome economic and financial fundamentals.

Let us hope that European policymakers return well rested from their August break. Theywillneedalltheenergyanddedicationthey can mustertopivotquicklyfromEurope’sforcednormalityto a more durable strategyforrecovery, or at least to stop drivers of renewed prosperity from slipping farther away before they can be harnessed.

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