The eurozone economic contraction, characterized by sharp drops in output and employment, is driven by fiscal consolidation by governments, through tax hikes and expenditure cuts, deleveraging in the private sector by banks and households, and loss of confidence in the eurozone's future by businesses and investors.
This contraction has eroded the patience of an increasing number of people who have lost faith in their governments and leaders as evidenced by the spreading political upheaval, which began last year in Greece and Italy and surfaced most recently in France and the Netherlands.
This political upheaval is nationalistic, and for the time being marginally extremist and xenophobic, rejecting the quest for the ever deepening European integration, which results in an increasing loss of national sovereignty. It could lead to a social breakdown, bordering on anarchy, with dire consequences. Germany, the eurozone's leader and taskmaster, whose efforts to impose iron fiscal discipline on not only the eurozone but the entire EU are backfiring politically and it too may not be immune to political upheaval.
In the World Economic Outlook (WEO) forecasts released last week, the International Monetary Fund (IMF) identified another acute crisis in the eurozone as the main risk to the global economy and financial stability. It projected in its baseline scenario, assuming away the risk of an acute crisis, the eurozone real gross domestic product (GDP), which grew 1.4 percent in 2011, to contract 0.3 percent in 2012.
But in the downside scenario that assumes an intensified eurozone crisis, similar to that in late 2011, the eurozone output could fall 3.5 percent over a two-year period relative to the baseline WEO projections. But that downside scenario does not encompass potential disorderly sovereign defaults and exits from the eurozone, most likely led by Greece, which can cause the breakup of the eurozone.
The recent decisions to enlarge the combined European Stability Mechanism (ESM) and European Financial Stability Facility (EFSF) and to substantially increase the IMF's financial resources to bolster the European and global firewalls against contagion cannot ensure the eurozone's survival in the worst case scenario.
The Markit (Flash) Eurozone Purchasing Managers' Index (PMI) for Composite Output, released on Monday, fell to a five-month low in April. According to Chris Williamson, chief economist of Markit Economics Limited, a global financial information services company, “the flash PMI signaled a faster rate of economic contraction in the eurozone during April, extending what appears to be a double-dip recession into a third consecutive quarter.”
The index has fallen for the third month in a row and seven times in the last eight months, indicating accelerating decline in private sector activity. Output fell in both manufacturing and services, with the former experiencing a steeper decline. Output in the eurozone periphery, which excludes Germany and France, the two largest economies in the eurozone core, fell more sharply in both manufacturing and services for the 11th month in a row, with the decline accelerating in the last four months.
But even in Germany output growth slowed down sharply, showing the weakest expansion in the last five months, the decline in manufacturing offset by weak service growth. In France output fell in both manufacturing and services for the second successive month, with the fastest decline since October. Eurozone composite employment fell for the fourth successive month and at the fastest pace since February 2010. Germany experienced its first employment drop since February 2010; France experienced its second successive employment drop, and employment in the eurozone periphery declined faster than that in the eurozone core.
Based on this bad news, here is what Mario Draghi, president of the European Central Bank (ECB), said in his carefully worded but gloomy statement at a hearing of the Committee on Economic and Monetary Affairs of the European Parliament on Wednesday: “Available indicators for the first quarter of 2012 broadly confirm stabilization in economic activity at a low level. Latest developments in survey data are mixed, highlighting prevailing uncertainty.” He added that “downside risks relate in particular to a renewed intensification of tensions in euro area sovereign debt markets and their potential spillover to the real economy.”
As the eurozone economic contraction continues, perhaps even worsens, it will cause more political upheaval. The opposition outside Germany to austerity measures, fiscal discipline and structural reforms will grow stronger. There will be rising pressure to raise government expenditures through deficit spending and have the ECB open the monetary spigot further by lending to governments directly as a last resort, despite the prohibition in its charter, to stimulate economic growth as quickly as possible. The result will be, at least in the short run, higher inflation and a weaker euro. Whether this is an outcome Germany, whose impossible dream is to have the eurozone become a fiscal union, which requires a political union, is willing to accept in order to save the rickety eurozone from extinction remains to be seen.