Europe's lost decade

Lausanne, Switzerland

The long-awaited agreement on how to bail out failed European banks has been welcomed here as a positive step towards a desperately needed banking and fiscal union in the eurozone. But talk to economists and executives from across the region and the consensus is that recovery is still 5-10 years away and before change takes place, many countries in the eurozone will have to come to grips with mass poverty.

European banks are awash with their countries' debt. Their balance sheets are choked with risky government bonds that they cannot offload elsewhere and, as a result, they are unable or unwilling to lend. European nations are awash with the debt of failed or failing banks – 1.6 billion euros since 2008. Painful austerity measures that have the duel effect of heaping misery upon citizens and throttling growth are the consequence of efforts to get this unsustainable debt down.

Banks and nations have been playing a death-defying shell game in order to prevent further contagion in the finance sector. Banks continue to loan to risky nations knowing their collateral (government bonds) may at any time be next to worthless because they need the support of sovereign governments if there is another financial shock – something which is still very much on the minds of Europeans.

Pier Carlos Padoan, deputy secretary general and chief economist of the OECD told Business Spectator that the risk of more financial shock is very real. The yield spreads between Germany and other countries in the eurozone are unwinding and that presents a new systemic risk, one that policy makers don't have the tools to respond to.

Rising yields put even greater strain on public finances as debt repayments get more onerous. Already the spread on yields has returned to pre-Euro levels, with Greece now back to almost 20 per cent higher.

Carlos Braga, the former special representative for Europe for the World Bank and now professor of international political economy at IMD business school in Lausanne, Switzerland says it is a question of trust. The high yields on government debt reflect the lack of trust in institutions and nation states to solve a crisis. That is why this banking union is seen as such an important step. In the US, the depth of the crisis saw Fed President Ben Bernanke adopt a range of measures from TARP to TALF to quantitative easing, to enact a relatively orderly unwinding of bad bank debts. In the eurozone, no such policies were available because there was no overarching body to coordinate a restructure.

As Arturo Bris, professor of finance at IMD puts it: "Between a sovereign debt crisis and a banking debt crisis, we chose a banking debt crisis." Until the banking crisis is resolved, he says, Europe will continue on its miserable way.

Pier Carlos Padoan of the OECD believes the banking union is a critical step toward saving the very idea of the euro itself. 

"No currency union has ever succeeded without evolving into a political union," he said. The European Union can work on stabilising sovereign debt, but the drag on growth is the banks. "Without a fully-fledged banking and financial system, any economic stimulus won't flow through to the economy." 

Given the current banking agreement has been on the cards for 2 years, it will be a long time before a full union can be achieved. The problem for Europe is that while Brussels and finance ministers fight for compromises, the no-growth scenario continues. Deep pessimism is the result. In a seminar on the outlook for the European economy at IMD business school, four fifths of the 100 senior executives in attendance believed that Europe faces a lost decade, much as Japan has.

For Arturo Bris, a Spaniard who teaches finance, the only outcome is deep pain, and possibly poverty for all the southern countries of the eurozone.

"In 10 years in Spain we went from relatively middle class to considering ourselves rich," he said. "Now we have to accept that is not true and we have to change our values when it comes to what the state can do."

Ultimately, that means more austerity and deep cuts to social services and ongoing youth unemployment, meaning it may be a generation before the European experiment will deliver rewards.

"The EU is not for us," says the youngish Bris, "—it's for our kids."

Jackson Hewett attended IMD's Orchestrating Winning Performance 2013 as a guest of IMD.