Franco-German slide suggests a return to bailouts

The euro zone is on the point of a lapse back into stagnation and deflation, which is bad for the rest of the world.

The twin engines of European economic growth are virtually running on empty. Both Germany and France, the two biggest economies in the euro zone, have had a torrid time in 2014 and the prospects are not good for the rest of the year.

In the second quarter, the German economy actually contracted by 0.2 per cent, while France stagnated. Overall, euro-zone GDP in the first half of the year probably fell a little, halting the tentative recovery that had been under way for the past year or so.

There is now talk of the need for another bailout by the European Central Bank (ECB) of the weaker economies that usually rely on Franco-German dynamism, or at the very least a further splurge of quantitative easing (QE). Italy and Spain will probably be the main beneficiaries of this aid, but the other peripheral countries will also need some assistance.

How did euro-zone policymakers get into this mess, while the rest of the world has largely recovered from the effects of the global financial crisis of 2009? It is an important question for the global economy, in which the currency bloc is such a big trading partner, and is also of interest in the UAE and wider Middle East region. France and Germany are big commercial partners of the Arabian Gulf and any weakness there would have knock-on effects for this region.

The German situation is the more intriguing because the country has such a reputation as an economic powerhouse and global exporter. The crisis in Ukraine, and the tit-for-tat trading sanctions between Russia and the euro zone, has badly hit confidence in Germany, a major trading partner for Russia.

But the decline was under way even before the Ukraine situation nosedived last month with the downing of a Malaysian civilian aircraft. German business has been holding back on investment for the past year, leading to lower industrial production and a decline in export orders.

In France, political inertia has compounded economic difficulties. The French dose of austerity delivered by the president François Hollande was never entirely convincing and now the government appears to have given up the policy, without actually admitting it.

It does admit, however, that it will not be able to hit the budget-deficit targets agreed with the ECB. In other words, it will continue to try to spend its way out of its problems.

European policymakers, led by Germany, imposed austerity on the euro zone in the hope that economies such as France, Spain and Italy would push through structural reform in the wake of the financial crisis. But that policy just has not worked and has certainly not been worth the pain inflicted on some countries.

The core economies of the euro zone have not benefited from any real modernisation measures and are now having to admit that they need a further injection of QE. The contrast with the rest of the world, which is coming to terms with life without US-directed QE, is stark.

But even if the ECB does go down the QE route wholeheartedly, there is no guarantee the policy will work, any more than the bailout for sovereign defaulters in the euro zone helped the peripheral countries.

The zone is on the point of a lapse back into stagnation and deflation, which is bad for the rest of the world.

The pains of the French and Germans must be causing some grim smiles of satisfaction in London. Britain, which really did embrace austerity for a few years, is back as the fastest-growing economy in Europe with 3.2 per cent GDP growth predicted for this year. Unlike its neighbours, Britain took the medicine as prescribed and now finds itself in a mini-boom, led by the fast-growing financial and other parts of the services economy.

Britain’s new-found economic dynamism could be ominous. The country, always half-hearted about the European project, has not really felt part of continental system since the euro-zone crisis began in earnest in 2010 and, if the core EU economies and Britain continue to diverge, it could make British threats to quit the EU for good self-fulfilling.

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