• Europe’s growth pickup hides weakness in the jobs outlook, banking woes, and convoluted politics
• The ECB’s new, unconventional monetary measures come late—perhaps too late to have much impact
• Consumers remain resilient while a modest rise in capital formation should underpin the recovery in the short run

It is a reflection of the eurozone’s darkened economic outlook that the European Central Bank (ECB) took dramatic new measures at its recent meeting. The ECB lowered key interest rates, expanded the size and scope of asset purchases, and offered financial incentives to commercial banks in return for on-lending money borrowed from its refinancing facility. At first sight, the eurozone’s headline numbers look encouraging: industrial production powered ahead at an annual rate of 2.9% in January while GDP rose 1.6% in the fourth quarter. For the record, U.S. manufacturing output runs weaker than in Europe while fourth quarter U.S. GDP growth came in only a shade stronger than in the eurozone.

These are the headlines but the reality is more nuanced. At 10.3% in January, the eurozone jobless rate mirrors the level of early 2012. The newly revised forecast for inflation now calls for a 0.1% annual rate by the end of this year and still markedly below 2% by 2018. At the same time, the stock of banks’ nonperforming loans is up sharply in some countries (Figure 1), while Europe’s key export markets (the Middle East, China, Russia) are weakening. Add to that the lack of scope or political will to prime-pump fiscally, and the eurozone’s outlook looks rather wobbly.

Figure 1 – Bank Nonperforming Loans as a Share of Total Gross Loans

Source(s): World Bank and MAPI Foundation

Given all that, if the ECB moves still look like desperation, they probably are, given several signs.

First, Europe’s economy is facing falling prices. This is not new (the MAPI Foundation singled out this risk earlier) but the trend is more pervasive in Europe than in the United States. Housing prices have not recovered from their 2008 levels in the eurozone, for example, and the pace of wage growth there has slowed down recently after a modest initial recovery. The effect of the already low materials prices is somewhat attenuated by a weaker euro. Consistently falling prices tend to depress the appetite for investment spending. If the trend is particularly entrenched, deflation could also put a damper on consumer outlays (we’re not there yet, though).

Second, the euro has not weakened as universally as is sometimes assumed. For example, while the euro did lose value against the pound sterling over the past two years, it strengthened against the Canadian dollar. And during the strong dollar rally between April 2014 and March 2015 when the euro lost a third of its value against the greenback, it strengthened by about a quarter against the renminbi. Canada and China are key export destinations; a stronger currency could cool off foreign sales there.

Third, the ECB and the Swedish, Danish, and Swiss central banks began charging interest on commercial banks’ reserve deposits over the past year. Amid a glut of savings that cannot be profitably invested in loans, such punitive rates squeeze bank profits because interest margins (the difference between rates charged on loans and rates borrowed from creditors) fall. Banks are important intermediaries in Europe; they refinance the private sector on a large scale and underwrite sovereign bonds. Add to that the unfinished business of cleaning up legacy assets from the time of the crisis and stricter capital requirements now being introduced, and Europe’s key funding channel looks stressed.

Finally, there is politics. EU voters put immigration overwhelmingly at the top of their concerns in recent polls, well ahead of economics. Immigration divides voters and upends existing political formations. As such, forming workable coalitions has already proven tenuous, as the recent examples of Spain and Ireland attest. Convoluted politics make for often-hesitant economic policymaking. The EU cohesion is also being tested. The prospect of Britain voting to leave the European Union in the upcoming referendum would surely inspire similar sentiments elsewhere in Europe. A disintegrated Europe would quickly lose investor sentiment and slide into a deep recession.

Will the new round of monetary stimulus deliver on its promise? The earlier rounds of quantitative easing justifiably propped up demand through the wealth effect on spending. More importantly, the ECB’s bold and unconventional action helped to dispel the uncertainty hanging over the crisis-tired economic prospects. This time around, none of the two effects is likely to bite as forcefully. Somewhat perversely, more negative interest rates would eat into bank profits, further impairing access to finance.

Yet the ECB is the sole remaining game in town with cards to play. The EU is paralyzed over refugees and divided over Ukraine, energy, and even TTIP. National governments face limits on fiscal stimulus that are capped by EU-imposed deficit bounds and negative market sentiment. Seen from far away, Europe’s central bank retains the aura of stability and credibility. In this light, regardless of how cogent its policies appear, they are appreciated for simply being put forth.

The full Issues in Brief archive can be found here.