Emmanuel Macron's ambitious plans to reform eurozone institutions received a further setback when German chancellor Angela Merkel toed her party's line and rejected some of his bolder proposals when the two met in Berlin last week. Merkel's stance makes it unlikely that any meaningful structural reform of eurozone institutions will be agreed upon at the EU summit in June. This piece analyses the eurozone economic risk outlook, given the low probability of reform in the short-to-medium term.
Disagreements over future of eurozone
The latest meeting between Angela Merkel and Emmanuel Macron last week reinforced the fundamental disagreements between the two leaders on the future of the eurozone. While Macron emphasized the importance of greater convergence between the eurozone economies, Merkel was keen to stress the need for compromise. She was clearly unwilling to expend any political capital and instead toed her party's hardline stance on structural reform. There are three central planks to Macron's proposals: the creation of a eurozone bank deposit guarantee scheme, the transformation of the European Stability Mechanism to a more permanent European Monetary Fund to weather economic shocks, and the creation of a fiscal union with a central eurozone budget.
There is simply no appetite in Germany for any reform that could entail transfers from German taxpayers to weaker eurozone countries. The CDU/CSU is wary of the challenge from the far-right Alternative for Germany, while the centrist Free Liberals are skeptical of closer European integration. Merkel, while broadly supportive of Macron's aims, has exhausted much of her political capital during the arduous negotiations over government formation and has not committed to supporting any of the substantive proposals. She has resisted the idea of creating a fiscal union, which would entail creating a central eurozone budget and has also rejected the creation of a bank deposit guarantee scheme for failing banks. The only area of agreement has been on creating a more permanent European Monetary Fund that would be better able to protect the eurozone in the face of macroeconomic shocks. However, the CDU/CSU has insisted that this process should be undertaken only after a treaty change which would necessitate the approval of national Parliaments. Therefore, there is unlikely to be much immediate progress on this front either.
These fundamental disagreements over the future institutional structure of the eurozone are unlikely to be resolved by the next EU summit in June. The summit is seen as the last opportunity to agree on some reform before the European elections next year. Therefore, the probability of structural reform in the medium term is extremely low.
Updated economic risk outlook given low probability of reform
The low probability of structural reform of the eurozone increases economic risk over the medium term, as it leaves the eurozone vulnerable to economic shocks. A common bank deposit guarantee scheme is essential to lower the probability of banks runs, while a permanent monetary fund will help to recapitalize the banks in an event of crisis and avoid a debt loop between banks and sovereign governments. A fiscal union with some form of debt mutualisation and central budget is equally essential if the monetary union is to survive. Without these institutional reforms, the eurozone economies are always left vulnerable to global economic shocks. Therefore, the recent lack of progress on creating these structures does increase economic risk over the medium term.
While there is no immediate sense of crisis, the risk trajectory is likely to increase gradually because of several economic headwinds both within the eurozone and globally. First, there has been an unexpected decline in the eurozone's economic activity. Various economic indicators have surprisingly underperformed this year. Most notably, German industrial production has taken a significant hit while business confidence indicators in Germany have declined too.
Second, the prospect of Brexit and the threat of a trade war with the USA constitute two significant global outliers that could hurt future growth in the eurozone. While the UK is likely to bear the brunt of the costs of Brexit, there is likely to be some disruption to eurozone economic activity too, depending on the nature of the final withdrawal agreement. Trade relations with the USA are uncertain as well because it is unclear how long tariff exemptions are going to last. These two global outliers inject considerable economic uncertainty and are likely to dent business and consumer confidence in the eurozone.
Ultimately, the lack of progress on structural reform coupled with looming economic headwinds means that an economic downturn is likely in the short to medium term.