The economic outlook in the European Monetary Union (EMU) took a turn for the worse last Thursday when the European Commission (EC) announced that growth in the region had stagnated and economies were facing a real possibility of a double-dip recession. This news was compounded by comments from Fitch which said that their recent surveys showed European investors now think a double-dip recession is three times as likely to occur compared with second quarter responses.

The EC said that economic growth is being stifled by the austerity measures governments are undertaking to appease debt markets. The Commission went on to predict that as a result of negative growth, government debt levels would in fact tick higher next year, creating a vicious cycle which looks difficult to escape. This type of cycle is very similar to what economists call a ‘poverty trap,’ a self-reinforcing situation that creates persistent poverty unless steps are taken to break the cycle. In this case, the downward cycle entails European governments that are slashing public spending to meet creditors’ demands, which in turn takes the wind out of the countries’ sails, slowing growth or plunging the nations into recession. This, in turn, lowers tax revenue and the governments’ ability to meet their obligations. Angry creditors then demand further austerity measures and so on. Essentially this leaves the nations with high borrowing costs and a recession – or at least stagnant growth – which are a disastrous combination; a scenario we are seeing play out in Italy.

One may rush to conclude this afflicts only the weakest nations in the EMU, however, it is also the mighty Germany that is facing a dramatic slowdown, although it should avoid negative growth. Forecasts for German growth in 2012 now show a paltry 0.8% - more than 1% lower than the EC forecasts in Q2. Other ‘core’ nations (Spain, France and Italy) are also now forecast to all grow below 1%; a pretty dire picture. Things get worse, Portugal’s economy is contracting so fast that it may miss its austerity targets, as the EC’s new forecasts for the beleaguered nation expect negative growth to the tune of 3%, a dramatic deterioration from Q2’s -1.8%. This would place Portugal even below Greece, whose economy is expected to contract 2.8% in 2012. The outcome for the EMU as a whole is that growth is going to slump to 0.5% in 2012 – a downward revision from the EC’s earlier expectation of 1.8% in 2012 – and only manage a modest 1.5% this year.

With Greece now something of an outlier, its future subject to much speculation and debate, focus has moved on to Italy, a nation that has the second highest debt ratio in the EMU of 120.5% of GDP and an expected growth outlook for 2012 of an anaemic 0.1%. It is not, however, the debt ratio or the growth outlook that invoke the greatest concern for officials but rather the sheer size of its debt: a galactic €1.9 trillion. This sum is so far out of the reach of the EFSF that it would make bailing out the EMU’s third largest economy virtually impossible. As we mentioned above, the nation looks to be teetering on the edge of entering a downward cycle which would be near inescapable, and without the lifeline of the EFSF one shudders to think where it could end for Italy.

Shifting back to the European Commission’s report, it was not all doom and gloom. The Commission did offer some substantive suggestions as to how to tackle these problems; starting with acknowledging these developments – that austerity could lead European economies into a downward spiral. To stimulate growth in the region, the EC wants to focus on structural reforms in economies, like liberalising labour markets and relaxing some restrictions which can lead to market inefficiencies. This to us, however, sounds like trying to plug a leaking dam with a bucketful of grout.

Written by Jonathan Granby

Jonathan Granby is a financial writer and blogger who contributes regularly to DailyFX, Seeking Alpha and is a regional contributor for Aslan Media. Jonathan is a published writer with pieces appearing in leading U.S. journals on the topics of economics and finance. He has previously held positions in financial services and before that was the Freedom Fellow at JIMS, an economic think tank.

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