Europe’s fundamentals sink despite investment surge

A strong wave of investments has flowed into Europe over the past couple of months, offering some observers hope that it’s a precursor of a sustained economic recovery and an end to the long-standing euro crisis. On the surface, it appears to be good news, particularly given that the eurozone recently slipped back into recession. But despite the injection of more than $135 billion in private investment towards the end of 2012, the latest economic indicators offer more cause for pessimism than optimism.

The split between what financial markets and the economic fundamentals are telegraphing about the future is confusing many observers. On the financial side, equity and bond markets, buttressed by the moves of the European Central Bank (ECB) in the fall to support government debt markets, have seen two very positive developments. One development is falling government bond interest rates, which is key because that makes it easier for some of the more desperately strapped governments to finance their large debts. The second development is rising equity markets. That suggests some companies may become more optimistic and could start to hire new workers in countries that have devastating unemployment rates.

As for why the stock markets are doing so well while real economies are doing so badly: “I think that quantitative easing is a big part of the explanation,” says Wharton finance professor Franklin Allen. “[Central banks] are buying up huge amounts of debt securities globally, and at least part of the money is going into equities and driving their prices up.”

Wharton management professor Mauro Guillen notes that bond markets have improved significantly in the eurozone because Spain and Italy have had de facto bailouts. “A bailout is needed if there is a problem with selling government bonds at an affordable interest rate. From this point of view, the ECB’s action in the summer to support the euro at all costs has made a difference. The risk premiums have come down – the ECB has been buying Italian and Spanish debt. So, in a way, they have already been rescuing Italy and Spain without going through a formal bailout.”

Last July, Mario Draghi, the ECB president, said his institution would do “whatever it takes” to avoid countries leaving the eurozone. Some countries wanted to exit in order to be able to create their own home currency, which they could then devalue to spark exports and get out from under crushing debt. The bank said it would ensure with financial underwriting that Italy and Spain could issue as much new debt as needed in order to finance the strict deficit-reduction programs now underway.

Ordinarily, the positive developments seen recently in financial markets might be viewed as leading indicators pointing to better days ahead. But these are not ordinary times. The problem is that these developments come against a worsening economic performance and not a stabilising outlook. The best recent example is Italy, which takes on outsized importance given that it is probably too big for the eurozone to bail out if that were required, particularly after the huge bailout measures directed at Greece, Portugal, Spain and Ireland. Here are some notable recent economic indicators for Italy:

 The Bank of Italy now forecasts a continuation, through much of this year, of the recession that started late in 2011. This month it cut its GDP growth forecast for 2013 from -0.2% to -1.0%.

• Industrial production dropped by 7.6% in November compared with a year earlier, and was down 1% from the previous month.

• In the first 11 months of 2012, production declined 6.6% below the 11-month period in 2011.

• Demand for fuel fell for the January-November 2012 period by 12% compared with 2011.

• This year will mark the 15th year in a row that Italy has recorded a decline in industrial production.

For Spain, Europe’s fourth-largest economy, the story is similarly grim. Unemployment hit a new record at 26%, and youth unemployment – which is decimating an entire generation of workers’ chances at securing good careers – is now above 55%.


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